PayPal Deep Dive

A complete exploration of this company, its prospects and risks.

Section 1 -- The Basics

1.1 A Brief Story on the Beginnings of PayPal

PayPal’s journey to digital payment ubiquity commenced in 1998 when it was created under the name “Confinity”. Confinity -- founded by Max Levchin and Peter Thiel among others -- was a software-based security program for hand-held devices and struggled to find any success. Perhaps ahead of their time, in 1999 the founding team subsequently evolved the focus to electronic payments. The new product concocted was called “PayPal."

Luckily, Confinity was founded with a security core. This fostered cutting edge payments innovation pertaining to privacy and data encryption and enabled it to find early success. The company quickly caught the eye of X.com, a new digital bank, and its charismatic founder Elon Musk. Soon after, the two merged at the turn of the century and PayPal went public at the tail end of the dot-com bubble in 2002. Early employees of PayPal formed what was called the “PayPal Mafia” and included a wildly impressive roster of talent including those already mentioned plus Reid Hoffman, David Sacks and the co-founders of YouTube.

Just months after PayPal’s IPO and strong success, it was purchased by eBay. From 2002-2014, under eBay’s wing, PayPal blossomed as the platform’s default payment option and achieved dominant market share in the process thanks to its preferential placement. But PayPal had ambitions well beyond a checkout button on eBay. Five years into the journey, PayPal secured a partnership with MasterCard and other financial institutions which freed it to vastly expand its merchant availability. At this time (around 2008), it was generating 150% of what eBay paid for it in annual revenue -- quite the purchase.

By 2011, PayPal’s product suite was morphing from checkout into a broader host of services including brick and mortar shopping, peer-to-peer (P2P) payment solutions and other M&A-based project. And from there, PayPal grew like wildfire; its future was as bright as ever and its revenue base had surpassed its parent company’s. Unfortunately, eBay’s future wasn’t so bright with the rapid advancement of Amazon and other competition. Identifying this, legend Carl Icahn pressured the combined entity to spin off PayPal in 2015. This is also when current PayPal CEO Dan Schulman stepped in to manage the next evolution.

From 2015-2020, a continued operating agreement between the two firms kept things largely unchanged and placid. The companies were separated, but continued to work closely during that 5-year period. That changed in 2018 when eBay announced it would not renew the operating agreement and would instead let it expire in 2020. That move meant PayPal would lose preferential checkout button placement on eBay’s page and would no longer be eBay’s processor -- its competitor Adyen securing that new contract. PayPal had been the preferred button AND the processor up until this point -- but no longer.

Over the last 24 years, PayPal’s colorful history has seen it transform from a single-product payment provider into an entity striving to build super-apps to power the financial lives of consumers. In the process, it successfully democratized access to financial services, achieved spectacularly consistent growth and established a market-leading niche within the crowded financial services landscape. Here, we will explore how it has been able to prosper in the past, and if it can overcome a competitive landscape that gets more difficult with each passing month.

1.2 Payment Ecosystem 101

a) The Digital Transaction Process and Players

Before going into how PayPal creates value, it’s imperative to understand the digital payments value chain, the process, its players and how PayPal fits into the full equation. PayPal’s online checkout offering is described by management as its “past, present and future” and it is intertwined throughout this ecosystem. So, we’ll explore this world from the point of view of PayPal. As we’ll see later on, it is aggressively expanding into new segments, but all of the other launches are dependent on the strength of the central checkout system.

Checkout begins when a customer has finished filling their online goods/services basket and is ready to pay for their selections. The customer can enter in credit/debit card information manually, or can use a payments provider like PayPal and login to have the data auto-populated once an account has been created. After a payment method is selected and the data is entered, the card information and all other identifiable account information is encrypted (AKA tokenized) by what’s called a gateway service. This can effectively be considered a digital point of sale (POS) system or a high-tech, digital cash register during the checkout process.

• Tokenization definition: Process of anonymizing sensitive card data by converting it to a string of continuously generated numbers called a token. This is very similar to encryption and the two terms are often used interchangeably. PayPal has tokenization partnerships with all card rails like Visa and Mastercard.

A Gateway offers many of the essential software connections to the rest of the landscape. It plugs a merchant’s site into online payment processors, integrates into card networks and connects to digital wallets to power consumer payment optionality. It’s needed for any online sales presence. Gateways also provide payment vaulting databases which serve as encrypted storage systems of consumer information. That is what enables the auto-populating services that payment providers such as PayPal feature.

Post-gateway data collection and encryption, this information is sent to a payment processor which does most of the transaction authenticating to ensure its legitimacy and legality. It’s the work horse of the equation and the second required merchant connection -- this time between gateways and the merchant’s bank. A processor moves the transaction funds through its network and back again, facilitates the settlement of funds and authenticates.

• Payment processor examples: Adyen, Stripe, PayPal, Braintree etc.

Authentication concludes with a request sent from the processor to the customer’s card issuer.

• Issuer examples: Bank of America issues a consumer debit card on top of a card network (rail) like MasterCard.

The issuer is the party ultimately responsible for approving the transaction -- it will do so largely based on account balance data. Processors authenticate and issuers authorize all in a few seconds. If approved by the issuer, it will then directly fund the transaction and communicate its decision to the rest of the ecosystem. Issuer funds will be sent through the processing network, back to the gateway and ultimately into a merchant bank’s (frequently called a merchant acquirer) deposits.

This merchant acquirer maintains and services merchant accounts within their deposits ecosystem. Post fund settlement, the acquirer immediately credits the merchant account for the sale amount. Settlement usually takes a day or two, and commonly, the role of merchant acquirer and processor are done by the same entity (such as Wells Fargo). Merchants must have one of these accounts in order to accept online payments through a licensed financial institution.

Finally, to compensate the consumer issuer for its transaction funding role, it directly debits the shopper’s approved account by the amount of the purchase. It’s worth noting that none of this process is visible to the front-end customer, but instead facilitated all through the back-end to ensure a slick, delightful experience. All a shopper sees is a receipt post-approval or a notice of rejection from the gateway.

b) Fees

Every party mentioned above that touches the transaction requires a fee for their participation:

• The interchange fee is paid to the customer’s issuing bank as a percentage of every sale. This is usually around 2% of the sale + ~$0.10.

• The assessment fee is paid to the credit card association (card rails such as Visa or AmEx). This is often combined with the interchange fee and quoted as one value, but alone it is typically around 0.1% of the sale + ~$0.10.

• The markup fee is paid to any other party involved in the transaction -- such as the merchant acquirer. This is usually around 0.25% of sales + ~$0.10 on its own.

• The authorization fee is paid to the processor for their services and is generally ~$0.30 per transaction. This is charged for all transactions: sales, declines and returns.

  • This is why a merchant bank/acquirer would ideally like to be the processor for every transaction as well -- they get a higher, margin-accretive fee. Still, these merchant banks readily plug into PayPal due to the vast digital distribution bump it fosters.

There are various methods for quoting these fees for merchants. Regardless of the method chosen, these costs are inherent in card-based commerce.

c) PayPal’s Role Within All of This

As briefly stated, PayPal is a payment provider. That classification means that it bundles the roles of checkout flow, gateway, processor and merchant account (through bank partnerships) all into one offering. It’s also now becoming a more prominent card issuer through its Venmo and PayPal revolving products. The gateway specifically is called “PayFlow Pro” which takes a $0.10 cut per transaction plus a $25 per month fee. This has largely replaced PayPal’s legacy offering called “PayFlow Link.” Please note that this payment provider niche does not include merchant bank or acquirer servicing. Instead, PayPal readily integrates with this piece of the ecosystem to provide end-to-end payment capabilities.

PayPal’s broad integrations and partnerships with the rest of the space mean that merchants can pick individual tools in an a-la-carte manner. It’s all about merchant choice, which is only possible with PayPal’s integrations that ensure reliable cross-vendor interoperability.

1.3 PayPal’s Product Philosophy

a) Build the 2-Sided Network

While PayPal started with a single service, it has built out a vast suite of utility-building products for both merchants and consumers. All of these products are aimed at supporting what PayPal calls its 2-Sided (consumer + merchant) Network scale. The wonderful thing about PayPal’s business model is that its success is intimately based on its stakeholders enjoying more payment volume through their networks, or convenience in their daily lives. It can only thrive by providing more value which eliminates conflict of interests. PayPal teamwork makes the dream work.

The Two-sided network creates a compelling flywheel:

• Happier merchants with more flexibility and options use PayPal more frequently.

• More merchant adoption means broader acceptance for consumers.

• This ultimately results in more successful merchants, more choice for consumers & greater revenue for PayPal.

• More merchants mean even happier consumers while the converse is also true. One side of the network directly augments the other.

The utility PayPal can provide to the consumer acts as a force multiplier for making PayPal more valuable to the merchant. It is with this singular focus that PayPal has rounded out its comprehensive product suite. This is how is wins: delight, delight and then delight some more. Many formidable competitors have addressed one of these sides, but none have achieved the satisfaction & scale duality that PayPal has built. This paves the way for PayPal to offer value that others simply can’t which we’ll explore in detail later on.

While PayPal has comprehensive solutions, it does divide its products into merchant-facing and consumer-facing. For consumers, this culminates in its two digital wallets while for merchants it takes the form of the “Commerce Platform” which integrates all of the enterprise utility PayPal provides into a unified B2B platform.

b) Revenue Generation

PayPal’s two revenue segments are labeled as transaction revenue (by far the largest) and “Other Value Add Services” (OVAS).

Transaction revenue is the compensation PayPal gets for operating its gateway, checkout, processing & merchant account services. It also includes other products like instant transfers of account balances and cross-border foreign currency conversions to facilitate international transactions. PayPal does not compete by undercutting competitor pricing, rather it does so through brand excellence (quantified later), checkout flow and scale.

As a result, PayPal’s all-in flat rate is 2.9% + $0.30 for the first $3,000 in monthly merchant sales. After that, it charges 2.5% + $0.30 until a merchant reaches $10,000 in monthly sales with 2.2% + $0.30 charged for all sales thereafter. For reference, Block’s flat fees are very similar with both having surcharges for use of non-traditional Alternative Payment Methods (APMs). Transaction revenue is consistently 91-93% of total PayPal revenue.

Key performance indicator (KPI) definitions pertaining to PayPal Transaction Activity:

• Active Account: Registered user within PayPal’s ecosystem (or an account registered through a platform access partner) who has completed a non-gateway-exclusive transaction in the last 12 months. One person can have multiple accounts meaning accounts and active users are two different things.

• Total Payments: Payments less Reversals through PayPal’s platform.

• Total Payments Volume (TPV): Total volume passing through PayPal’s platform or a platform access partner using PayPal.

The other 7-9% of revenue creation is via PayPal’s OVAS. This is all other revenue generated from things like partnerships, deal discovery, subscription fees, referral fees, PayPal’s merchant credit offerings and net interest income on select customer balances.

In terms of U.S. and international split, PayPal’s revenues are 53% domestic and about 47% international. This leaves PayPal vulnerable to currency fluctuations vs. the U.S. dollar which it actively hedges whenever possible. As a reminder, a stronger dollar means international revenue is worth less when converted back to dollars. Considering how rapidly the U.S. dollar has risen lately with it now roughly at parity with the Euro, PayPal’s hedging efficacy will be put to the test in 2022. But currencies always fluctuate and that won’t change; for this reason, all calculations done in this thesis are done on a spot rate basis without FX conversion rate adjustments. It’s just part of being a global entity.

c) Partner Frequently

PayPal’s ambitions are to offer essentially all basic financial services, but it extensively uses partnerships to bring this vision to life. Within categories such as checkout, payments and commerce where it’s able to deliver what it sees as tangible differentiation, it builds internally (or buys and integrates assets if it can’t). Conversely, for many financial services, it taps into financial institutions (FIs) to provide the licensing, usury exemptions and know-how to launch their products within PayPal’s environment.

As a standard rule of thumb, PayPal seeks out these partnerships within commoditized products like savings accounts. It takes these partner capabilities and laces its own interface throughout them to build use cases without creating disparate experiences within PayPal’s apps. The way to stand out here is via broader distribution. PayPal copiously provides that to these FIs to form a compelling win-win: Institutions gain coveted scale, and PayPal is able to offer more utility and revenue enhancing products.

“As PayPal launches products, our partnerships deepen. We’re one of the largest digital distribution channels for FIs and becoming an increasingly large piece of their growth. The new volume we create accrues to them.” — CEO Dan Schulman

This culture of openness has created a seamless path for joint go-to-market risk management and tokenization capabilities with Visa, Bank of America and others. PayPal also boasts a direct connection between its peer-to-peer (P2P) payment networks and AmEx’s while AmEx allows its card rewards to be used on PayPal and Venmo. This integration has been so successful for AmEx that it now advertises the capability to its vast user base. All other card rails offer integrated instant transfer capabilities with PayPal as well.

Furthermore, most major FIs including Bank of America and J.P. Morgan allow for card tokenization and linking into PayPal’s digital wallet. This isn’t unique to PayPal, but it’s a pre-requisite for any digital wallet’s success. Additionally, recall that PayPal’s expedited checkout process relies on its aforementioned gateway vaulting service to securely save and store needed information for future use. These institutions add more than a quarter trillion cards to the mix.

“Major FIs put their reward points in PayPal for customers to use them with any of our merchants, rather than redeeming them on an internal catalog with maybe 1-2 merchants. It’s a real value add for credit card issuers to offer rewards in more places.” — CEO Dan Schulman

The analyst community used to fear that credit card issuers or rails would be the death of PayPal. Not only has that proven to be inaccurate, but the opposite has been true. It has seen consistent renewals and partnership advancements from bellwethers like Citi. PayPal and FIs collaborate quite well together, and that’s the way it should be to create an aligned incentive environment that optimizes consumer value.

d) CEO Dan Schulman’s Two Transformative Priorities

PayPal’s most recent digital wallet upgrade and overhaul took 7 whole years. When embarking on my research in the company, that was one of the things that first stood out to me in a not-so-positive way. Most companies today are on continuous software release cycles which enable constant, interruption-less iterations.

Well, Schulman noticed this too when he took over in 2015 and made it his priority to make PayPal more innovative and nimbler within software advancement. This ambition took shape in two ways. First, he spent heavily on re-vamping the company’s technology to orchestrate more expedient and consistent software updates such as the external crypto transfers capability activated last month. The company had been leaning on dated, monolithic C++ code and spent hundreds of millions to transform that static backbone to one that is now exponentially more service-oriented, easy to use and utility-building. Specifically, the all-important digital wallet (covered extensively next section) will now be updated constantly.

As clear signs of these investments bearing fruit, PayPal has recently seen its software release cadence soar from a few hundred annually to tens of thousands while its bug rate simultaneously sank. Furthermore, the company’s up-time rate has risen from 99.99% to 99.999% this year. I know this doesn’t sound significant, but when you're processing trillions of dollars for hundreds of millions of accounts, it does matter a lot.

This modernization freed PayPal to tear down the walls of its product data silos so product teams can now work together with more data, more context and therefore more precision. The evidence of this collaboration bearing fruit comes in the form of rising authorization rates -- and for PayPal that rate has risen by a brisk 600 basis points since 2018 on top of the lead it already had vs. the industry (quantified later). If you know the customer better, you can typically authorize over 90% of transactions vs. around 75% for single-interaction companies -- and PayPal knows its customers as well or better than anyone else in the industry.

To power even more organizational agility, PayPal is finalizing a years-long process of creating digital twins or “evergreen systems” that enable its teams of software engineers to conduct constant split testing without ANY system downtime.

This makeover has had another interesting impact on the company’s approach to M&A. Previously, PayPal consistently guided to $1-$3 billion in annual acquisitions, which investors had long come to expect. It removed this piece of guidance as Schulman’s infrastructure reinvigoration changed the company’s view on what it can develop internally via R&D, and what must be bought. This is good news.

“Three years ago if we wanted a new product, we would have had to buy something for billions. Now, we feel we can do more organically.” — CEO Dan Schulman

The second item Schulman spent heavily on was compliance and risk management. Product release cadence -- especially in the highly regulated space of financial services -- relies on strong relationships with agencies and lawmakers. This is especially true if you want to expand internationally like PayPal has done. Regulators decide which services a vendor can provide and how they’re specifically able to be presented. Consequently, PayPal has been focused on cultivating strong governmental relationships since its inception, but Schulman has taken things a large step further.

Under Schulman’s leadership, the company’s risk management and compliance team soared from 120 in 2015 to over 4,000 today. This expansion has walked hand in hand with the technology modernization. A cutting edge software stack frees a company to be nimble while its regulatory prowess allows that nimbleness to actually be implemented and rewarded. PayPal brings both strengths to the table which is somewhat unique in FinTech. This edge allowed it to launch more products in 2021 vs. its entire history combined and enabled it to be the first foreign entity with a domestic Chinese payments license… ever.

“If you want to be a major financial services player, you have to be world-class at regulatory compliance… some thought regulation would slow us down, but no. We are better at this and it’s a foundational part of who we are.” — CEO Dan Schulman

e) The Market Opportunity

PayPal’s democratization vision is well-placed with 72% of Americans stressed about their finances. The firm estimates its current total digital transaction volume opportunity at a whopping $110 trillion which has grown 6-fold since 2018. Assuming a conservative 1% PayPal take rate, this implies that PayPal’s total addressable global revenue opportunity is north of $1 trillion dollars. PayPal thinks this revenue opportunity is closer to $2 trillion, but I think it’s good to lean pessimistic in market size calculations just to be safe (calculations are very subjective). And a $1 trillion market is still massive.

For global e-commerce growth specifically, estimates for 2022 are around 10-12% growth with modest acceleration expected in the future from vendors like GrandView as we distance ourselves from the pandemic shock. Much more on this later. The company fully expects to continue outpacing global e-commerce growth and gaining market share in the years to come.

The two tailwinds that will help drive its expansion are e-commerce penetration and cash displacement. With 70% of all global commerce via cash in brick & mortar settings as of 2021, the runway is long and full of opportunity for PayPal for years to come.

PayPal’s offline opportunity (retail brick & mortar) is lower margin, but it’s also an $8 trillion market. And the added brick and mortar use cases have also been shown to boost a PayPal user’s online engagement overall. PayPal’s rising offline entrenchment makes a user’s transition to the digital world happen more frequently with PayPal. To put it simply, offline is the bridge to more online volume.

Section 2 -- Checkout

2.1 PayPal Checkout for Merchants

a) Various Merchant Checkout Products

PayPal has a few different checkout products for merchants -- all of which handle payment card industry (PCI) compliance. Furthermore, each plan provides vaulting capabilities, thus eliminating the need to enter billing, shipping and delivery information for transactions after creating an account and linking a card. That’s largely how it expedites the transaction process and improves the user experience.

“Nobody in the Western world has the amount of data and information that we do in our vaults to help merchants.” — CEO Dan Schulman

Here, the partner philosophy shines with its ubiquitous card integrations providing merchants and consumers with the broadest payment optionality.

PayPal is now using these vaults to eliminate logins, making purchases even easier with one-click checkout for customers. Easier means higher conversion rates and a deeper competitive advantage. That same data is even being leveraged to target customers with valuable promotions upon domain entrance.

The company’s basic checkout option is called PayPal Standard Checkout. This allows for PayPal and card acceptance through a merchant’s site or marketplaces with zero setup or termination fees. This is the famous PayPal checkout button in its simplest form and is free for all merchants to offer. PayPal handles checkout, gateway servicing, processing and the merchant account while the actual transaction is authorized and facilitated on a PayPal-hosted site. Post-authorization and issuer approval, the transaction is sent back to the merchant for completion.

This 3rd party hosting is somewhat limited for two reasons. First, it means that the merchant enjoys zero user experience (UX) customization capabilities in the checkout flow. Furthermore, Standard Checkout forces shoppers to work through multiple sites and interfaces -- they have to actually leave the site and come back. Both issues lower conversion rates.

The next option is called PayPal Advanced Checkout. Unlike Standard, Advanced requires heavy PayPal vetting as it provides merchants more power to transact on their customers’ behalf. Approved Advanced merchants can do things like add or tweak purchases on a bill so that the customer doesn’t have to do it themselves. This jurisdiction comes with great responsibility -- hence the vetting. Advanced Checkout still relies on a PayPal-hosted portal, but here that page is actually embedded directly into a merchant’s website. That allows for slightly more customization tools for merchants and higher conversion via the in-line flow.

Advanced offers more thorough payment processing capabilities than Standard and broader integrations into more card issuers. Importantly, it can also process manually entered card data for returning customers. Conversely, Standard offers an error message when someone tries to manually enter in the data of an already-linked card. Customers often forget their cards are linked.

Finally, PayPal offers PayPal Pro/Custom Checkout which starts at $360 per year and is generally for larger enterprises. It features vast scalability and is fully merchant hosted meaning granular UI/UX customization which allows a merchant to mirror the theme of its own site. PayPal is still powering the gateway, processing and merchant account, but does not host transactions under this plan. With Pro, merchants also receive native integrations to accept ApplePay, Google Pay, AmEx Checkout and more.

b) Cross-Border for Merchants

PayPal’s deep global regulatory relationships have created a seamless international expansion capability for merchants. Its broad integrations do things like allow buyers to transact with their favorite local payment methods (LPMs) while PayPal handles all of the currency settlement, tariff and duty compliance. It takes the headache out of manually setting up a new business and payments chain in every new market that a business enters.

PayPal also includes its merchant protection programs (more later) which allow merchants to avoid the approval vs. fraud/loss correlation trade-off inherent within global e-commerce. With PayPal, that’s not the case -- they get the higher approval rates but without the coinciding higher losses. As a result, at the end of 2021, 65% of small and medium businesses (SMBs) in the USA using PayPal had cross-border businesses as opposed to under 5% for all others.

c) BNPL for Merchants

We can’t talk about PayPal Checkout without talking about Buy Now, Pay Later (BNPL) -- an installment loan product gaining speedy momentum within commerce. PayPal debuted its BNPL product in the United States and has expanded quickly to other core markets like the U.K. and Germany. The company expects BNPL to be its largest credit product in the future, which is encouraging considering it’s less capital intensive than its other revolving credit products. PayPal has a range of options in the space -- based on payment schedule and transaction limits -- which are collectively referred to by the company as its “Pay Later” solutions.

Regardless of where you look, long term growth forecasts for the BNPL space are robust and range from 25%-46%. Younger generations do not like interest payments; PayPal Pay Later allows them to avoid that burden. In Australia where pay later products are more mature than any other nation, 8% of all digital checkout is funded via BNPL vs. rates of less than half that in all other developed nations. Worldpay sees this BNPL penetration rate globally rising to 13-14% by 2024: the runway here is quite long and PayPal is poised to dominate. Clearly, BNPL is becoming a more central piece of consumer checkout preferences which, obviously, means merchants are highly motivated to offer this solution to stay on-trend. PayPal makes that easy.

Existing PayPal Merchants aren’t required to do any integration or on-boarding work to offer PayPal Pay Later to its consumers. All they have to do is turn it on as an option. Merchants not only gain access to PayPal’s nearly 400 million consumer accounts, but they don’t even have to assume any balance sheet risk in the process. PayPal funds all of these transactions and stores the loans on its own balance sheet -- merchants are paid immediately. It assumes the credit risk for the merchant. All of this value must fetch a hefty price tag, right? Wrong. It’s actually free for merchants to use with PayPal charging its typical payment provider fees.

Rather than charging for access to this service, PayPal benefits from the added BNPL volume. The average merchant volume boost when the service was launched in 2020 was 15% and has grown to 21% since then. This incremental gain directly accrues to both PayPal and the merchants. It features an up to 82% merchant conversion rate boost while the overall traffic is 90% additive (not cannibalistic) for these merchants. How can this be? Interestingly, PayPal BNPL users have shown to lean on it for shorter-term and smaller buys while using its revolving products for their other purchases. To make things even more appealing, 70% of PayPal BNPL customers are repeat buyers within 6 months, which is much higher than typical repeat rates.

All of that value is likely why PayPal has been able to rapidly add 1.6 million BNPL merchant accounts. That metric is currently growing at 33% sequentially.

For merchants like Samsonite, simply adding a PayPal BNPL option raised the entire company’s AOV by 36% while yielding a 205% rise in overall Pay Later volume. Higher AOV means better margins and added revenue. As an aside, Samsonite also purchased PayPal’s inventory management which solved its frequent glut issues to offer a unique perk for PayPal to differentiate vs. other BNPL vendors.

When looking across other merchant case studies, the outcomes are similar. Jewelry Television enjoyed an 85% AOV spike while DXL used PayPal Pay Later to foster a 25% incremental rise in Gen Z customer reach in just 60 days. DXL also experienced a 3.5X lift to its overall revenue growth rate -- amazing results for a free product requiring no balance sheet risk.

For yet another worthwhile merchant bonus, PayPal’s extensive customer transaction history means its approval rates are routinely above 90% just like for the rest of its operations. Conversely, competitors that are lacking transaction history data boast typical approval rates that are 1500+ basis points lower. This is precisely why it’s vital for BNPL to be just one tool in a tool kit like it is for PayPal -- rather than the entire offering like for many others.

“We’ve got higher pay later approval rates & lower loss rates than any other vendor in the industry… this is a good service, but not a company by itself” — CEO Dan Schulman

It’s good to intimately understand the customer via uniquely extensive and leverage-able profiles on each of them. All of PayPal’s products in aggregate are what help to build this lucrative awareness. That knowledge has freed PayPal’s BNPL credit delinquencies to be stable as recently as June 2022 while others have seen theirs precipitously rise.

“We see the articles around credit delinquencies, but we’re a bit unique. We’re not immune… but we feel good about our position. We have dense customer data… the vast majority of all our BNPL is with existing PayPal customers which is a different position than stand-alone BNPL firms trying to learn on a one-off transaction basis. This is a credit product and we said that from day 1 even when it wasn’t in vogue to do so. But it is a credit product and we take it responsibly.” — PayPal Head of Consumer Doug Bland

PayPal’s consumer Pay Later adoption has been strong per MoffettNathanson. It jumped from 0% to 5% penetration within the top 500 internet retailers in just a year. PayPal expects to lead this category over time with management telling us every single quarter that the product continues to “rapidly gain share” (as recently as May 2022) and that this was its “best organic product launch ever”. Its most recent Pay Later volume growth was 256% YoY, indicating continued strength.

I believe that growth and market share gains will accelerate going forward as much of PayPal’s competition here is -- as leadership calls it -- “VC-funded contra revenue for placement operations.” This type of firm should quickly fade away as the cost of capital rises and liquidity diminishes. To put it bluntly, macroeconomic volatility has a way of eliminating weaker competition.

Today, PayPal’s Pay Later products are for terms of up to 12 months and $10,000 -- both limits were just raised. In terms of what’s next for this segment, the firm’s overwhelming success is resulting in more of a focus on tools and perks being folded the BNPL umbrella.

To me, the most exciting development here is something called “Upstream Presentment.” This simply means that PayPal’s BNPL and other checkout options are displayed sooner in the shopping process on the product page. That type of placement features the same one-touch checkout covered above and boasts PayPal’s highest conversion stats out of any other transaction format. This is the biggest reason why PayPal entered BNPL, not because it’s a great profit driver on its own (it isn’t), but because it’s a wonderful means for securing preferential checkout treatment. This drives even more volume which ultimately does drive its success.

“Upstream presentment placement is why we went so heavy into BNPL. It’s not the economics of BNPL alone.” — CEO Dan Schulman

Specifically, upstream placement alone raises PayPal’s share of branded checkout by a full 10%. For context, PayPal has roughly 25% checkout share with a partner like Shopify -- another 10% bump with some of its merchants is a massive boost. Younique (an e-commerce engine for female entrepreneurs) is a great example of the power of Pay Later upstream presentment: Post-implementation, it saw a 209% rise in overall Pay Later volume and PayPal commanded more than half of that share. Younique is so pleased with the results, that they promoted this tool to other organizations, for free:

“We hit the jackpot with PayPal Pay Later. We want to tell the field that this is available and why it is so important for engagement, volume, AOV and flexibility.” — Younique Finance Director David Serpa

This not an isolated incident but a bit of a cliché -- and a heartening one at that for PayPal. Omaha Steaks saw a 10% spike in AOV by implementing Pay Later upstream and saw its overall customer base become materially younger. That was something it had struggled with for years. Unsurprisingly, these trends have paved the way for rapid merchant upstream placement progress:

BNPL = More Profitable PayPal:

PayPal’s overall transaction margin benefits from BNPL as well. Yes, it gets the added volume which is quite important, but it gets more than that. BNPL funding sources are debit and ACH at an 85% clip and rising. These methods of funding are far cheaper for PayPal to facilitate as assessment and interchange fees are lower or non-existent in some cases. Accordingly, BNPL has a 16% lower transaction cost than all other funding options. As we’ll see later, PayPal’s take rate trend over the long term has been lower; this is one of the many ways it can become a more efficient company to counteract that pressing margin headwind.

Paidy:

While the bulk of PayPal’s Pay Later ambitions have been built internally, it did buy Paidy for $2.7 billion last year to enter the space in Japan. Japan is the 3rd largest e-commerce market in the world with Paidy providing instant access to the 10 largest marketplaces and all convenience store chains in that nation. PayPal mainly operated a cross-border business there pre-acquisition -- this opens the door to do FAR more. 70% of all transactions are conducted digitally in Japan, but ultimately settled in cash: The cash displacement runway there is longer than most other developed nations. These were the main reasons for the purchase while a few million net new active Pay Later users and 200 capable employees were bonuses.

Paidy offers several Pay Later products which can be settled in convenience stores (a central part of Japanese culture) or via bank transfer. The two companies had been close partners for years and PayPal was even a founding member of Paidy’s gateway service. The Japanese company’s founder and its CEO both stayed on and remain with PayPal post-transaction. Always a good sign.

d) Marketing (Honey, Store Cash etc.):

A key piece of PayPal’s merchant value within checkout comes from that aforementioned ability to provide extensive information on nearly 400 million consumer accounts. It offers the standard integrations into all relevant sales channels such as Google and Facebook, and uses its special consumer scale to go deeper than competitors can go.

For example, PayPal Store Cash is a program that identifies “almost-buyers” or those who started, but didn’t finish the checkout process from its a database of 392 million+ shoppers. Merchants get a curated list of these relevant and interested consumers to re-target with promotions to lure them back in. To boost accessibility for smaller merchants, PayPal solely charges for access to this service on a performance fee basis. It takes 8% of incremental sales generated from the merchant which nurtures some stellar return on ad spend (ROAS) metrics.

The key driver of advertising performance is targeting granularity. When you’re sending out messages to millions simultaneously over linear TV, that granularity is a pipe-dream. With PayPal’s almost 400 million consumer profiles and detailed, actionable information to target on a person by person basis -- that pipe dream morphs into a reality.

“PayPal is the best partner we’ve had in my experience. Store Cash was one of the strongest wins we’ve ever seen.” — Mattress Firm VP of Product Management Sumo Das

PayPal’s new and improved app -- with decades of machine learning algorithm built in -- is even nimble enough to offer dynamic merchant promotions display only to the highest intent app users. This newfound ability is pushing PayPal even further upstream from product page to site entrance, bolstering its command of the checkout process even further.

Beyond these programs, the Honey acquisition a few years ago entrenched PayPal deeply into deal discoverability. As we’ll explore in detail in section 3, this platform has generated services like “Wish Lists”. These effectively serve as a history of what a consumer has expressed interest in (through clicks & opens) to gauge concrete demand.

e) Merchant protection programs

Merchants using PayPal for checkout get access to its fraud and risk seller protection programs, free of charge. No other company does so for free and this is yet another PayPal competitive advantage. The company is doing everything possible to make its stakeholders happier to incent more volume passing through its ecosystem. It’s all about them. The merchant protection program relies on PayPal’s expertise in assessing each transaction with hundreds of factor-engineered variables to determine legitimacy -- in real time.

If a transaction is approved and a merchant sends the good or service in the condition promised, PayPal guarantees their payment no matter what. This, paired with PayPal’s buyer protection program (the reciprocal consumer equivalent), effectively makes it a clearing house for digital transaction participants. That’s a powerful tool for ensuring confidence from both parties to conduct and approve more transactions.

“These protection programs are generally much broader than similar protection provided by other payment industry participants.” — PayPal’s 10K every year since IPO

Simility:

PayPal bought Simility in 2018 to gain proficiency in fraud detection and subsequently re-branded it as PayPal Fraud Prevention Analysis (FPA). This is a key piece of PayPal’s industry-leading protection programs for merchants and buyers. PayPal wanted Simility for its Adaptive Decisioning Platform and infused that into its own “Risk-as-a-Service” (RaaS) feature. It also offers FPA on a standalone basis. Simility is a crucial piece of PayPal’s fraud detection and its edges in authorization and loss rates which, again, is a game-changer in the world of e-commerce.

It uses things like its behavior profiles to flag deviations from normal engagement by stitching available data into a singular birds-eye-view of each customer. It also helps PayPal provide promotion abuse protection by uncovering malicious new account creation. This results in more accurate transaction underwriting which improves overall loss rates and juices volumes -- quite the win-win.

f) PayPal’s Brand -- The True Merchant Prize

Merchants enjoy loyal PayPal customers:

While all of the perks above are great, simply the presence of the PayPal brand may bring the biggest statistical benefit of all. The following studies from independent 3rd parties reiterate that sentiment in an unbiased manner:

According to a Nielsen survey of 15,000 online shoppers, PayPal converts customers at a 28% higher clip when selected at Checkout vs. the average alternative. PayPal also delivers an aggregate 19% rise in unplanned purchases, 13% more repeat purchases and happier customers with an overall +8 impact on merchant net promoter scores (NPS). All this, just from adding PayPal Checkout.

PayPal’s risk management and checkout flow edges yield that aforementioned 6% higher authorization rate for merchants vs. industry standards without impacting loss or fraud rates. That advantage -- which is up from 4% as of 2020 -- means that merchants convert 6 more transactions per 100, while consumers are rejected and thus discouraged less frequently. This quarter, CEO Dan Schulman hinted that the lead is now closer to 8%. Regardless of which metric is accurate, it’s a massive impact. Again, PayPal provides the coveted holy grail in online payment: More approvals and lower loss rates.

And in an e-commerce world where cross-party reliability is imperative, PayPal delivers. A Morning Consult survey of 300,000 people revealed that PayPal is the 2nd most trusted brand in the entire World. Data from Netfluential mirrors this result with 53% of respondents trusting PayPal to keep their data safe vs. less than 4% for the other 6 financial service innovators in the study. When handling a consumer’s sensitive data and finances, trust is like gasoline to a combustible engine. You’re not going very far without it.

IPSOS (in conjunction with PayPal) ran a study a few years ago painting a similar positive theme of PayPal fostering more merchant success. They determined that customers are 54% more likely to complete checkout with a merchant if the PayPal button is present. Notably, tens of millions of PayPal surveyed consumers admitted to abandoning an online purchase because PayPal was not a payment option. If you were a merchant, would you implement PayPal’s checkout option with no on-boarding cost to get these tangible benefits? I certainly would.

When consumers trust you more than others, it gives you permission to sell them more and more things. As we’ll see in the next section on PayPal’s digital wallet, that’s the plan.

Governments love it:

Not only does the PayPal brand build consumer confidence, but it comes with tremendous global regulatory clout as well. The huge investment that PayPal infused into building the teams to massage these relationships was both tedious and cumbersome -- but the regulatory connections now serve as a deep moat against competitors. This is why PayPal has been so effective in providing cross-border services and why merchants can use PayPal for compliant global payment expansion. As a notable bi-product, the government affiliations also free PayPal consumers to pay in their preferred, comfortable local method regardless of location.

The clearest evidence of PayPal’s regulatory prowess comes from China. Again, it’s the only foreign company in that Nation with a Chinese Payments License -- and this took them just 6 months to secure. Considering how protective the Chinese government is of their consumers and economy, this was nothing short of amazing. The relationship came from PayPal’s outright purchase of GoPay and gives it complete access to the massive Chinese market.

With the license, PayPal can provide Chinese merchant checkout service to open them up to 392 million customer accounts globally. What’s even more exciting is that China’s nearly 1.5 billion people can now shop at PayPal’s 35 million merchants across the globe. PayPal can also now process Chinese taxes, customs and tariffs and can clear transactions in local RMB -- none of which it could do pre-license.

The license also freed PayPal to strike lucrative partnerships with multiple key players. Notably, it partnered with UnionPay to link the Chinese Giant’s 1 billion+ cards into PayPal’s ecosystem. PayPal will now be a payment method at all UnionPay merchants (so pretty much all Chinese merchants) and vice versa. Together, the two also offer PayPal QR codes, which can be used by tourists instead of requiring WeChat or Ant Pay downloads. Outside of China -- throughout APAC where UnionPay is prominent -- the tie-up permits PayPal to link UnionPay cards into its digital wallet in Australia, The Philippines and other countries. Finally, PayPal signed a contract with Alibaba allowing it’s customer to use PayPal for checkout globally.

This license was a big get for PayPal, but I don’t think the tailwind has yet been enjoyed. China is just now trying to come out of its latest pandemic supply port shut downs which have made global commerce a nightmare. These issues have been stubborn, but are also temporary. As the Chinese economy eventually re-opens (now with monetary stimulus to support it) PayPal should be one of the only American Fintechs positioned to materially gain.

In Europe, it was able to secure a banking license in Luxembourg to unlock many new services thanks to the coinciding lower cost of capital and new authority. This has allowed business segments such as its merchant credit facilities to explode in popularity in nations such as the U.K and has opened the door for new use cases in countries like Italy as well. The company was just added to Italy’s Public Administration App which enables PayPal to be used for bill, tuition and tax paying to the Italian Government. Another great sign.

In the United States -- where PayPal is regulated by the Consumer Financial Protection Bureau (CFPB) as a “money transmitter” (not a bank) -- the regulatory grip appears to be tightening. Very recently, this government agency has commenced research into things such as AI/ML and its impact on fostering bias within financial services. While this increased scrutiny will be tough to maneuver for some companies, PayPal has invested in the level of regulatory compliance needed to position it for success regardless.

“We think it’s great to see regulators imposing the right mandates and programs to protect consumers. We’re a partner in that process and have built a platform to enable us to do right by the customer always… there’s a myth that security and innovation can’t both be done. They can.” — PayPal CTO Sri Shivananda

Not only does seasoned regulatory expertise facilitate product launches, but it makes PayPal a prime initial integration candidate for Central Bank Digital Currencies (CBDCs). Central Banks will not give up total control of digital currencies and they are quickly working to digitizing their own fiat forms to stay modern. According to the Bank of International Settlements, Central banks representing 20% of the world’s population will have CBDCs issued by 2024 and PayPal is best positioned benefit.

g) PayPal’s Market Share

If everything above in this section were the cause, market share would be the effect -- and for PayPal, signs are all positive. Its overall merchant checkout placement is 8X the next closest digital app with Apple Pay the only competitor materially closing that gap.

When the pandemic re-shuffled the competitive landscape, PayPal showed its effectiveness by taking another incremental 2% checkout share from the competition as leadership frequently reiterates. Amid chaos, it relatively outperformed. Today, it boasts a dominant market share lead with the largest global merchants and that lead has proven to be quite sticky over the last several years. Specifically, in the company’s most recent quarter, it lost share with 5 of its 55 largest customers, gained share with 17 of them and maintained share with the rest.

For now, the main point to make here is that PayPal’s checkout share continues to grow with concrete, quantifiable advantages paving the way. Slowing industry e-commerce growth as we lap pandemic comps is temporarily dampening the rewards from these market share gains, but once e-commerce growth re-accelerates, so will PayPal’s.

2.2 PayPal Checkout for Consumers

Merchant value creation is just one piece of the equation. That value skyrockets when complemented by a large cohort of customers like with PayPal. Who cares about accurately targeting promotions and conversion-juicing features if no consumers use the service? Short answer: not merchants. That’s why consumer value creation to encourage usage is imperative and that’s why PayPal is also keenly focused here.

a) Convenience, Security and Trust

In the checkout and “button wars” world where competition is fierce, it’s vital for PayPal to differentiate wherever it can. Checkout is largely commoditized at this point which makes differentiation difficult but immensely lucrative if attainable.

PayPal stands out here by minimizing clicks and time to checkout while maximizing security, authorization and privacy for the customer.

It accomplishes this in a few ways. First -- as briefly mentioned -- PayPal’s gateways encrypt and vault sensitive customer data so that users are guaranteed anonymity and also don’t have to manually enter in the information for each checkout. With PayPal -- after creating an account -- the data automatically populates, allowing consumers to breeze through. Easy and convenient.

With its newer One-Touch offering -- requiring no new integrations or installations for merchants -- consumers with a PayPal account can race through checkout even more quickly. After a card has been saved with PayPal and a consumer has logged into a certain device, they simply select PayPal, confirm the purchase and they’re done. For a large merchant like StubHub, this feature immediately delivered 50% more revenue per customer than its other checkout options combined and positive outcomes like this are common.

PayPal also offers the aforementioned consumer protection program alongside the merchant program; both are broader and stronger than most alternatives. With fraud and unscrupulous behavior as rampant as it is within e-commerce, this is a big deal to people as it works wonders in curbing the consumer losses incurred from this issue. It means PayPal is footing the fraud bill, but it’s a necessary cost to pay to stand-out in the crowded checkout field. All of this seems to be working based on the brand trust surveys covered above.

b) Global Adoption Ubiquity

Convenience and security are a great foundation, but that foundation blossoms into something so much more prized when it’s combined with leading merchant adoption. And with PayPal’s previously stated 8X placement rate lead and broad partnerships, it delivers in droves.

A turnkey cross-border service in 200+ countries helps drive this ubiquity too. As you can imagine, PayPal acceptance in more countries and its ability to offer more local payment methods (while competition can’t) are wonderful tools for it winning churned customers.

As an aside, if you’re noticing a theme of me using the terms “aforementioned” and “briefly stated” it’s because PayPal’s consumer and merchant utility is generally built in concert. The two sides of the network are intimately intertwined and each must be nurtured to support the other.

c) BNPL -- Summary of consumer BNPL utility:

• No late fees (unlike others) or interest rates on payments.

• Broader payment flexibility.

• Direct integration into the digital wallet.

• Omni-channel usability.

d) What’s Next?

Going forward, the focus will remain on reducing latency whenever possible -- it eliminated several seconds in 2021 -- and crafting delightful experiences. Updates like proactive card expiration notices along with making more of checkout in-line have been two of the many tweaks that delivered this positive result. And there’s still a long, long way to go. PayPal users still only select it as a direct option half the time that it’s available: there has been remarkable success to date, but the low hanging fruit remains abundant.

Finally, as briefly discussed, the company is actively phasing out login request prompts. Since forgotten information accounts for half of PayPal’s churn, successfully removing this piece of the checkout process would be a nice conversion tailwind. Shockingly, roughly 95% of that data is on the dark web anyway, so this is no longer a reliable assessment of identity verification and it will be replaced over time.

Section 3 – The PayPal Digital Wallet (Super-app)

3.1 The product suite for consumers:

a) Basis of the Launch

PayPal’s digital wallet, accessible via mobile app or desktop, is just another name for its product suite. As a reminder, the digital wallet launch last year marked the completion of a 7-year upgrade process, but updates will now be constant thanks to Schulman’s internal transformation. The update involved extensive split testing to observe data driven preferences and to refresh the app that management frequently referred to as “tired and “antiquated.”

This is leadership’s fix for that ailment and to become the consumer’s daily financial app. Some of these additional tools are value extenders for its traditional checkout flow while others create new use cases entirely with the aim to support consumer engagement and diminish churn. This has become an increasingly important aim for PayPal. Today, the digital wallet is rolled out to half of PayPal’s user base with plans to get that rate to 60% by 2023.

A key theme to keep in mind with this release is getting the most out of PayPal’s data treasure chest. With its nearly 400 million consumer accounts and extensive transaction histories, PayPal can use all of this data to create a more granular, personalized app experience. Now when a consumer doesn’t click on a certain icon enough times, that piece of the feed goes away. In the past, experiences were far more static and uniform as PayPal’s product teams had existed in isolation, and just didn’t work together to augment things like underwriting and UX. That’s no longer the case. Beyond getting more out of PayPal’s unique data scale, the team fixated on making more experiences native to the PayPal app to avoid having to ship consumers off to potential competition with an interface disruption. Let’s dive in.

b) The Consumer Options

The three main service categories for consumers are payments, financial services and commerce -- and it has dedicated app tabs for each of them.

Payments:

Payments is the original service. It comes with the same peer-to-peer payment features that the firm has been featuring for decades and ubiquitous card linking capabilities for checkout usage. Whether it’s account balances, cards, QR codes, internal or 3rd party rewards, bank transfers, gifts and more, you can use it in the wallet. This is why it’s called a digital wallet -- all physical cards and funds can be digitally stored in it to function as a virtual, comprehensive container for your financial livelihood.

Beyond payments, the app provides native bill pay flexibility with new auto-pay and reminders, as well as crypto and rewards available as funding tools. Through a partnership with the billing company Paymentus, billers and aggregators are able to display invoices directly in the PayPal app. Previously, bill pay happened largely outside of the PayPal ecosystem and this small update alone has powered a 200% spike in first time users. That spike not only means more revenue, but also affords PayPal a superb indirect benefit of infusing more data and accuracy into its credit issuance. Generally speaking, if I know you can pay back your bills on time, I can offer you cheaper and more frequent credit.

The partnership frees PayPal to use Paymentus’s processing network while offering a uniform UI/UX to augment the quality and consistency of the offering. This is a clear example of PayPal’s partnership bias when it comes to largely commoditized products. In addition, PayPal added a large cohort of billers and aggregators into its integration network ensuring that consumers can pay bills through the wallet regardless of who their vendor is. Consumer choice is key.

Financial Services:

Financial services is where we start to see some real changes. This app page offers customers a high yield savings account with a 0.85% APY (raised from 0.4% in early 2022) which is around 12X the national average. Companies like SoFi offer more yield, but PayPal thinks it can rely on its brand trust to thrive with a rate that’s high, but not the highest in the industry. This product features no fees or balance minimums and boasts extensive budgeting tools to guide users on a path to financial health. PayPal’s consumer credit card, with its 3% cash back for all transactions, is another piece of this product segment. The hefty rewards work to create healthier users capable of contributing more to merchant volumes -- simple enough.

Within Crypto, PayPal offers the standard buy/hold/sell products. Similarly to PayPal’s BNPL approach, this crypto debut was entirely organic and, within 60 days of launch, achieved results that shattered all management expectations. By then, 17% of PayPal’s hundreds of millions of users had already transacted Bitcoin through the platform -- per Mizuho. So far, Bitcoin, Ethereum, Bitcoin Cash, and Litecoin are the currencies offered with many more coming.

But PayPal takes digital currency adoption a step further. As of last year, the firm’s users can actually use virtual currencies to fund purchases at any PayPal merchant. To offer this unique perk, PayPal partners with Paxos for licensing, liquidity and custodial services and is working on securing integration partners to enable brick and mortar tap to pay with Crypto as well. While the crypto commerce tool sounds cool, it really hasn’t gained much traction to this point -- and PayPal expected that.

Schulman really sees crypto for transactions as a placeholder for when CBDCs are broadly available in the near-ish future. By having this ability in place -- coupled with the previously covered government relationships -- PayPal will be well-positioned to integrate these federal coins into their wallets. CBDCs and digital wallets are like peanut butter and jelly and PayPal is determined to be an intimate part of this.

“We’d like to see crypto evolve from price hype to the utility that blockchain can provide to the payments industry.”  — CEO Dan Schulman

The company is also focused on how blockchain technology can expedite expensive, inaccessible clearing processes for electronic money transfers. CEO Dan Schulman believes distributed ledgers technology (DLT) can solve these inequalities and that it will serve as the foundation of future payment rails. And he’s putting PayPal’s money where his mouth is. He created a standalone block chain unit to focus entirely on DLT and PayPal has also made some investments in the space to supplement its activities:

PayPal recognizes all crypto revenue on a net basis, not gross. This prudent decision insulates its financial metrics from aggressive fluctuations in crypto prices and trading volumes. That decision will serve it extremely well as monetary conditions continue to pressure these risk assets.

At some point this year, PayPal will debut equity trading. That tool has been in extremely high demand from its user base and the firm is happy to oblige.

Rounding out the financial services are products like 2-day early direct deposit access (through bank partnerships), cash checking and the ability to redeem rewards and/or use BNPL for purchases both online and now in-store. While PayPal’s past has been online, its future will be omni-channel and the digital wallet was created with this vision in mind. Through its Zettle point of sale system, it can do cool things like identify customers as they enter a store via geofencing, target promotions to those customers and also automatically check their rewards points at physical checkout.

Per Schulman -- and most industry leaders -- the lines between online and brick & mortar are blurring with the pandemic vastly accelerating that trend. As the offline market is factors larger than e-commerce, PayPal is focused on expanding here as well. But this expansion isn’t just about a change from swiping to inserting to tapping. It’s about bringing the flexibility associated with online payments to the physical commerce world. The firm is partnered with countless POS systems (in addition to having its Zettle offering) like Clover and Fiserv where PayPal is the default payment mechanism for those vendors.

It remains early days for PayPal brick and mortar, but the positive halo effect is already crystal clear. PayPal’s active in-store customers deliver 54 more annual transactions per account in addition to their online activity. That boost essentially doubles company engagement and leadership has frequently stated the benefit may be even larger. As a PayPal cardholder (through Venmo), getting this card definitely raised my own engagement with the company and has done the same for my peers.

The organization can also use this physical selling vector to concurrently expand a merchant’s digital ambitions. For example, PayPal’s physical QR utility allows merchants to onboard loyalty program members at the point of sale with the tap of a button.

All of these financial service features have that same engagement ambition in mind, but something else as well. The money-in tools incent more direct deposits with PayPal. When customers can pay bills, invest and shop for whatever they want in-app or in-store, that expands the appeal of depositing into PayPal while greatly benefitting the company.

Specifically, the firm enjoys a 56% increase in customer lifetime value (CLV) when this happens and also gains higher checkout margins. How? Direct deposit users fund transactions with internal PayPal balances -- its most profitable funding source -- at a far higher clip. It’s yet another instance of PayPal creating win-win-win scenarios: consumers gain more convenient access to financial services, PayPal benefits from the added CLV and merchants end up enjoying greater volume. What’s not to like?

Commerce:

Third -- and to me the most interesting part of the new app -- is the commerce page which closely and intentionally builds on PayPal’s checkout marketing products like Store Cash. This is the result of the firm integrating the full set of capabilities from its Honey acquisition into its nascent but swiftly emerging deal discovery business.

Today, Honey has a dedicated tab in the wallet. This tab features deals from millions of familiar brands intelligently and relevantly sourced for the shopper to explore. If you love and shop for a brand, Honey knows that (& utilizes it) without sharing sensitive information. It pastes together every consumer datapoint, marries it with PayPal’s added insights and forms an effective portrait of possible tastes and demand. It allows for targeted, highly pertinent deals to juice shoppers’ conversion and AOV. Relevant and private is a great marketing combination for consumers and is paired with the same PayPal Buyer Protection Programs its users know and love.

Honey is also now being leveraged to realize PayPal’s goal of moving all the way upstream to when a shopper enters a site. BNPL moves it upstream from checkout to product page while this moves it from product page to site entrance. The higher up it goes, the more checkout share it gets.

Furthermore, interesting deals can be automatically saved, tracked and even locked in for future usage if you’re not ready to make the purchase. That feature functions as a high tech “wish list” as Schulman likes to call it. Honey and the Commerce tab bring PayPal’s vision of “Contextual Commerce” -- or meeting buyers where they are with what they want -- to life in a truly unique fashion. Honey’s built-in rewards program can also be redeemed for use in-app and right at the point of sale in-store.

Even post-purchase, PayPal has its customers covered. Happy Returns offers easy returns at thousands of locations without needing a box to remove any and all friction. This is yet another key tool for PayPal’s omni-channel expansion and with a quarter of e-commerce purchases returned, it’s an important one. PayPal’s Chargehound automates the customer chargeback process, morphing it into something more pleasant.

When building customer utility, relevancy and abundance is how a company stands out. As we’ve covered, PayPal delivers on those needs with it fostering a 100X boost to Honey’s merchant reach post-M&A.

Honey’s value actually becomes even more concrete with deteriorating macro conditions. According to a several thousand person survey it commissioned, nearly 80% Americans think deal discovery became more important this decade. 20% of participants admitted to spending an average of 200 minutes per week searching for coupons (which Honey does for you). As inflation rages and budgets are stretched, this fixation on prices will be an advantage for Honey. Encouragingly, PayPal’s Head of Consumer Doug Bland told us recently that Honey is nimble enough to pivot from discretionary to necessary purchases during these times. It has done just that to stay most relevant and valuable to its shoppers.

Honey’s founder George Ruan continues to lead the company under PayPal.

3.2 Digital Wallet for Merchants (AKA the Commerce Platform)

a) Merchants Follow the Consumers

The main way to create value for merchants within the digital wallet is by designing products that attract more consumers -- and it does just that. According to PayPal leadership, its digital wallet fetches a 60% global consumer preference rate with the next closest being at 8%.

3rd party studies come to a similar conclusion. PYMNTS ran a survey of 15,000 consumers across 11-nations where in countries such as Germany, PayPal has an 83% market share within digital wallet transactions. Civic Science conducted a 4,500 consumer survey in the U.S a few months ago painting a similar picture. Of the digital wallet user respondents, 36% used PayPal as their primary digital wallet which led 2nd place Apple at 20% and Venmo (PayPal-owned) at 16% (combined PayPal/Venmo 52%). The two primary reasons for this lead were revealed as security and convenience. Finally, PwC ran a 1,000 person survey on PayPal brand awareness vs. the competition and it lead the pack by a wide margin. With digital wallet payments expected to continue gaining share of overall commerce, it’s good to be the market leader.

PayPal makes tapping into this clear consumer preference easy as well. The company has an end-to-end on-boarding process that plugs into these consumers all with one simple integration. There’s no need to commence a costly rip and replace process with PayPal or even implement new hardware. Its industry relationships ensure seamlessness and harmony with all other vendors.

b) How Merchants and PayPal Benefit

Financial Services and Payments:

Bill Pay allows countless legacy players (without a slick digital presence) to tap into PayPal’s dexterity and intuitively list bills online. While just over 10% of bill payments are late or never happen, it is usually not due to affordability. The primary reason is that people forget to pay, and the in-app nudges that PayPal provides work wonders for boosting on time payments and so lowering vendor delinquency rates.

With the High Yield savings product, PayPal has made payment transfers from this balance to commerce balances instant and seamless. The firm gets to use all of this balance data (which is all unique to it) to do things like raise its approval rates for customer credit -- again helping merchants convert more buyers and sell more.

Its crypto tool was also built with the merchant in mind. How? PayPal converts the digital currency to fiat so that merchants can simply accept more transactions in their native currencies. There is no merchant integration work needed, and the added payments flexibility offers a small boost to their conversion and AOV. PayPal is enjoying 25% lower churn rates for crypto users and these accounts are daily active users at a 50% clip -- far higher than the rest of its user base. More engagement juices volume and user growth for PayPal which ultimately results in a value flow-through for merchants.

Crypto activity is also great for PayPal’s transaction margin profile. Why? Purchases with Crypto are comparable to using a PayPal balance to fund transactions. This means no 3rd party assessment or interchange fees. Furthermore, PayPal collects a separate fee for conversion AND pockets a bid-ask spread in the process as well. In an ideal world, crypto would be used for all PayPal transactions, and that may be feasible if CBDCs become omni-present over time.

Commerce:

The Commerce tab is where things get mouth-wateringly compelling for merchants. Those individualized wish lists discussed above function as concretely expressed demand curves from a potential buyer cohort that’s larger than the U.S. population. Merchants are able to explicitly observe who is actually interested in their products and can target person-by-person deals towards them accordingly. Advertising does not get much more precise -- especially when compared to purchasing giant blocks of impressions in up-front markets with little visibility.

Schulman and PayPal intentionally worked on intuitive commerce discoverability within the new digital wallet, by doing things like creating the dedicated tab, and it’s paying dividends. Compared to PayPal’s old app, deal discoverability and conversion have grown by factors of 25X and 7X, respectively. This outcome is not possible without having an enormous base of both consumers and merchants. Without the consumers, merchants wouldn’t care about the product because there’d be no incremental demand. Without the merchants, PayPal wouldn’t be able to provide the deals it needs to attract more customers. The 2-sided network truly is a difference-maker. Interestingly, PayPal generally sees brief engagement dips whenever it introduces a new experience or interface -- it simply takes users time to adjust. For the digital wallet launch, however, this did not happen. Instead, engagement spiked immediately. Clearly, users were yearning for the upgrade.

The digital wallet has also already reduced customer churn which is vital to fortify PayPal’s net user and volume growth. Specifically, digital wallet users are engaged with the app at a 13% higher clip than legacy users and these users contribute double the annual revenue ($100 vs. $50) vs. checkout-only users. Every single new product added by a consumer juices revenue per account by 25%.

My favorite piece of evidence pointing to satisfied merchants is within recent advertising trends. As merchants observe the positive windfall associated with more PayPal Checkout, they often promote these payment options in their own ad campaigns. Free marketing for PayPal. Specifically, FanDuel’s current national TV campaign lists PayPal and Venmo as the only two digital wallet payout options on its site. Home Chef now messages rejected shoppers to remind them to use PayPal due to the concession-less authorization rate boost. Merchants don’t do this to be nice, they do it because it’s good for business.

3.3 The digital wallet market:

The digital wallet market looks to be a lucrative tide that will continue lifting all participating boats. PayPal’s traction within it should therefore be a powerful growth driver going forward. Juniper Research sees a 48% digital wallet CAGR through the next several years, Transparency Market Research sees a 22% CAGR through 2031, Fortune Business sees a 29% CAGR through 2028 and BlueWeave Consulting sees a 25% CAGR through 2028. Clearly, rapid growth is expected for a long time as cash displacement continues; few are even remotely positioned as well as PayPal to take advantage of that.

With mobile payments still representing under 25% of total commerce in the markets it serves, the runway is lengthy and momentum strong. Going forward, PayPal sees two greenfield opportunities to serve as reliable, long term sources of digital wallet growth:

• The Governmental Digital Payments Space (CBDCs).

• Business-to-business (B2B) facing payments solutions.

Both of those markers are larger than PayPal’s current opportunities… combined.

Section 4 -- Braintree

4.1 About Braintree

In addition to the branded value of the PayPal and Venmo digital wallets, there’s a key, non-branded piece of PayPal’s Commerce Planform: Braintree. To me, this is the most under-appreciated aspect of the business. PayPal bought Braintree in 2013 for 3 major reasons: To upgrade its tired technology stacks, create a white-labeled payments offering and for Venmo (covered next section).

Braintree features similar architecture to PayPal Checkout as PayPal has borrowed much of Braintree’s UI/UX for its own flow. The key difference is that Braintree keeps the merchant brand as the central focus. Most merchants can gain a lot from the added consumer confidence associated with PayPal’s brand presence. But others don’t require it and don’t want another brand on the site to compete with their own. These generally massive, universal firms are the brands that flock to Braintree.

4.2 Braintree + PayPal

Braintree began as solely a payment gateway with hefty vaulting capabilities and expedited checkout. It was the pay-in expert that granted large merchants a broader range of payment solutions, immense scalability and a slick, intuitive interface. That’s worth highlighting: PayPal bought Braintree for the vast API upgrade it provided. All of PayPal’s branded products are heavily influenced by Braintree’s technology -- and this influence has enabled things like fully in-line, merchant native checkout to raise conversion. PayPal leadership calls Braintree its “most sophisticated asset base” every chance it gets as it has paved the way for more seamless in-line, merchant native checkout.

• Application Programming Interfaces (APIs): APIs are blocks of code that enable software to perform various tasks. APIs act as the ‘language’ that empower access to data services, operating systems, and other applications to create an end product. A user interface (UI) is what the consumer sees and APIs are what the enterprise uses to build the platform’s UI and user experience (UX).

I’d just like to mention that PayPal got all of this -- including $100+ billion in annual processing volume (10%+ of PayPal’s volume) compounding at a 2-year clip of 70% -- for $800 million. A good purchase to say the least. But I digress.

Prior to the acquisition -- as merely a gateway -- Braintree submitted payments to traditional processors such as PayPal and merchant acquirers like Wells Fargo. It was responsible for ensuring that the right credentials were sent to the right processor based on bid matching to identify the best option.

Post PayPal acquisition, Braintree has blossomed into a full-stack, end-to-end payments provider with the same gateway, processing and merchant account offering as legacy PayPal. Today, that transformation allows it to more formidably compete with other capable vendors in the space like Stripe and Adyen (two kings of the segment). Merchants can still select individual Braintree services and seamlessly plug into other vendors -- but now it can do everything that its merchants require.

Braintree offers Fraud Prevention Analysis (FPA) for free, PayPal’s immediate pay-out service (“Hyperwallet”), Happy Returns, Chargehound and more to augment its utility creation. PayPal also allows Braintree merchants to use its 392 million customers for all of the same omni-channel marketing programs branded customers can utilize. Essentially, PayPal’s tools are all able to be white-labeled for Braintree’s own differentiation. So PayPal used Braintree to aggressively refresh its own infrastructure, while Braintree used PayPal to accelerate its product roadmap.

To be blunt, no other white-label end-to-end processor can offer what Braintree + PayPal bring to the table -- not even Stripe.

4.3 Where Braintree Shines

Braintree’s edge comes from its localized, yet global reach. It’s the driving force behind PayPal’s ability to plug merchants into local payment methods (LPMs) around the globe to ensure ALL customers can pay how they want to. And doing so is delightfully easy for these merchants. All it requires is one simple “Drop-In UI” integration which takes just minutes even for those least comfortable with software navigation. This interface, unsurprisingly, is essentially a brand-less carbon copy of PayPal Advanced Checkout and has found wonderful traction. But you don’t have to take my word for it, positive Braintree case studies are a dime a dozen:

“We had huge problems with existing processors before Braintree. It’s one of the best decisions we’ve ever made and gave us tools nobody else had.” — Pressed VP of Digital Commerce Blaine LaBron

The “Pressed” and KrispyKreme outcomes lead us to another interest point. PayPal and Venmo generally get more preferred button placement with Braintree’s clients. That allows the organization to garner a second, higher margin fee from merchants. Braintree merchants don’t have to offer this preferred treatment, but most voluntarily do so anyway. I wonder why?

Braintree is also the only full stack processor that offers seamless integrations with PayPal and Venmo. And considering how young and in vogue Venmo’s user base is, this is probably why international juggernauts like Uber, Messenger, Google, Airbnb, Live Nation, Spotify, Yelp, American Airlines, TikTok and more all use Braintree for the vast majority of their payment processing.

“We’re winning more extremely large customers with Braintree.” — CEO Dan Schulman June 2022

4.4 What’s Next?

While Braintree serves many of the largest digital “card-not-present” retailers, its next significant growth area will be within card-present, physical retail transactions. Vineyard Vines was the first merchant to launch with this newer offering in 2021, but momentum here appears to be strong. According to PayPal’s VP of Large Enterprise, it had “dozens of Fortune 500 retailers” in the works as of May 2022.

Section 5 -- Venmo

5.1 Venmo’s path:

Venmo started in 2009 as solely a peer-to-peer (P2P) payment provider with its culture centered around community and socialization. It was purchased by Braintree in 2012 and then joined PayPal in 2013 as part of that transaction. Its virality was born from its user base’s word-of-mouth enthusiasm and their ability to see where friends are spending through the Venmo feed. Today, the target user for Venmo is generally younger, more highly educated and higher earning than PayPal’s as a whole. It also skews more female. And interestingly, there’s very little demographic overlap between Venmo and its nearest competitor, Cash App, which caters to a different type of client.

Similarly to the PayPal app, the Venmo team is actively enhancing and broadening its product offering. It’s on the exact same Superapp path -- although further behind. While PayPal has a 2X Average Revenue per Account (ARPA) opportunity, Venmo’s is 10X based on how much earlier it is vs. PayPal in terms of monetizing and global expansion.

For years, Venmo had prided itself on its start-up culture. It didn’t want to be seen as a giant corporation, and so it distanced itself from the PayPal umbrella. Under new Venmo Head Darrell Esch, that philosophy has pivoted -- and in my view that’s a large positive. This transition includes Venmo embracing the enterprise-level capabilities of PayPal and readily tapping into them. Starting in 2020, it began using PayPal’s world-class protection and risk programs, its compliance team and its relationship with Synchrony bank to launch the Venmo credit card.

The teams had frustratingly been operating in parallel in these areas, which is obviously a waste of money and energy. Now, Venmo is determined to launch every service that PayPal has in its suite and will use PayPal’s experience, infrastructure and relationships to do so while powering cost synergies in the process.

This needed philosophical shift also means Venmo will lean on PayPal’s international product teams to streamline its own future international expansion. This expansion hasn’t yet started, but should find immediate traction with Venmo’s unaided brand awareness in future markets like the U.K. already above 30% with zero marketing efforts. This is the impact of P2P in action: Yes, it’s extremely low margin, but it’s also a fabulously efficient means of organic user growth. Venmo will use this low margin growth to expand into higher margin products with its 85 million+ engaged users.

Venmo is still the same innovative, nimble self -- just with new enterprise capabilities. This nimbleness beamed throughout the pandemic as Venmo transformed into the “virtual pickle jar,” with examples like tipping musicians exploding in popularity overnight. That allowed Venmo’s growth to actually accelerate in the face of lockdowns despite being a product largely reliant on physical world engagement and socializing. As a result of this pull forward, Venmo did see a user growth spike which has led to difficult recent YoY comps -- but those growth rates have now normalized into Summer 2022 per Doug Bland.

5.2 Venmo for consumers:

The company has been extremely methodical in adding new monetization features for its fiercely loyal consumers.

“We’ve been very cautious to ensure that when we add Venmo monetization features, we’re doing so in a way that resonates… the last thing we want to see is users start leaving the platform and we’re just not seeing that... there’s so much value to unlock and we’re early innings.” — PayPal Head of Consumer Doug Bland

Last spring, Venmo leaned on PayPal’s Paxos partnership to launch its own buy/sell/hold crypto product with crypto-funded checkout introduced a few months ago. Within months, 30% of Venmo users (so ~25 million people) were already using the new perk which raises Venmo CLV from $10 to $35. It expects to follow in PayPal’s footsteps with an equity investing launch as well.

As briefly mentioned, Venmo debuted its first credit card through PayPal’s Synchrony partnership last year. It expects all transactions to be done digitally in the future and will use these physical cards as a bridge to that point. Synchrony is the exclusive issuer here with Visa serving as the card rail. According to Synchrony, this program has been a top ten initiative for it with the launch eclipsing its most optimistic hopes. Venmo customers have long asked for more instant fund flexibility, and this new revolving credit product does just that.

The card yields 3% cash back for a consumer’s top spend category, 2% for the 2nd category and 1% for all others. As of late last year, these rewards can be used to make crypto purchases or easily redeemed for fiat balances as well. Venmo’s software core here really shines with the card integrated into the popular app. This allows for things like easy-to-access budgeting tools and seamless purchase splitting from within Venmo. The card can be used at physical locations via tap-to-pay or chip scanning as well. The face of the card is actually a QR code which takes you right to the holder’s profile simply by aiming a phone camera at it. This makes paying back on-the-go an even easier process and allows the person funding a transaction to immediately pay down their Venmo credit balance.

Morphing Venmo from a peer-to-peer payments engine and feed to something resembling more of a Super-app doesn’t come without growing pains. For years, Venmo’s user base had become comfortable and familiar with the product and its flow. As a result, Venmo created feed tiles to advertise the availability of new perks on top of a user’s UI. The base will familiarize itself eventually, and when that happens, these lucrative impression placements will likely be sold to merchants as a new advertising revenue stream.

5.3 Venmo for Merchants

To date, Venmo’s revenue has been largely generated by instant transfer -- with standard P2P transfers being free -- but that’s going to change. Why? The Federal Reserve’s Real Time Payment (RTP) network developments continue to be on-schedule which will provide free instant transfers. Venmo will not be able to rely on this revenue channel for long, and it’s well aware of that. Still, its instant transfer fees don’t seem to be fragile at the moment with it recently raising its take from 1.5% to 1.75% and the maximum fee from $15 to $25.

Venmo is working hard on building out its commerce use cases in ways that emulate PayPal checkout, but with other products mirroring the culture and vibe that made Venmo a verb.

First is Venmo Business Profiles. Until recently, there was no way to create business Venmo handles for accepting peer-to-business transfers. That is now available with merchants able to create free business profiles and accept online payments. This leverages the local feel of Venmo’s app community. How?

Remember the social feed which made Venmo so sticky? With business profiles, this basically serves as personal business endorsements from friends and family voting with their wallets. It’s safe to say that this is a more powerful growth channel than the “take-my-word-for-it” type marketing. Business Profiles greatly enhance a local merchant’s ability to tap into friends of friends and so on to efficiently and economically grow their following in a truly Venmo-style.

The business profile perks don’t stop there. This tool trailblazes a free means to operate an omni-channel business. Without any new hardware, merchants can print QR code stickers which transform smart phone backs into mobile POS systems that securely accept payments anywhere. These purchases come with PayPal’s standard buyer and seller protection programs.

To make things even more appealing, they’re cheap. Business profiles -- through Braintree -- can enjoy gateway, processing and merchant account services for 1.9% + $0.10 per transaction. This is up to 100bps cheaper than most options (including branded PayPal). All of this value is fueling rapid adoption. Over one million merchant accounts were created during the program’s first full year in 2021 and momentum is exceedingly strong.

Business Profiles has been where Venmo commerce has focused and found most of its traction to date, but it has ambitious long term plans for a Venmo checkout product more similar to PayPal’s. The leadership team fully expects this to eventually be Venmo’s “largest revenue contributor by far.”

Last year -- under Venmo’s new “better-together” philosophy -- it upgraded its Checkout product that infused many of the best parts of PayPal’s checkout flow. The old checkout process worked quite well when fully integrated into an app. For traditional real-time e-commerce purchases however, which is where leadership sees the largest opportunity, Venmo needed work. Before this launch, to checkout using a Venmo account, a shopper had to select PayPal and seek out Venmo buried within that option. There was no stand-alone button which created confusion and friction. It now features a stand-alone button that takes you directly to the Venmo app for checkout completion. Since this refresh, merchants such as Starbucks, Ticketmaster, Fanatics, Lyft and Booking.com all signed on as checkout customers.

There’s also a sizable marketplace you may have heard of called Amazon that is launching a Venmo checkout option on its own site this year. Amazon has been passionately protective of its checkout process to date, and so this integration speaks volumes about the value of the Venmo user base -- even for a commerce giant like this one. It’s safe to say Amazon isn’t opening their iron vault for fun, but because it will augment their financial results.

“We’re actively working to ensure we stay relevant to a new generation of consumers and Venmo is essential to that mission. If you want to be around in 40 years, you may want Venmo.” — Adorama CTO/CIO Hani Batla

Business profiles + Checkout round out the Venmo commerce vision. With Venmo’s monetized purchase volume growing 4X the rate of the rest of that business, this vision is clearly well-placed.

5.4 Venmo’s Success & Progress

Venmo’s rise in electronic payments has been nothing short of admirable. Here are the key trends:

PayPal had 85 million Venmo users as of Q1 2022, so this will be higher by end of year; revenue is based on current guidance; Volume comes from an overly pessimistic forecast.

Zelle includes volume from roughly 7,000 Financial Institutions combined

These numbers deserve some more context. In 2017, PayPal was at a $230 billion volume run rate and was growing 25% YoY. Today, Venmo is operating beyond that scale with a 44% YoY volume growth rate. Venmo has seemingly even higher upside than the PayPal app had many years ago. Going forward, Venmo expects revenue growth to briskly outpace volume growth as monetization ramps. It also anticipates profit growth to “significantly” outpace revenue growth implying future margin expansion. It turned operating profit positive in 2021 and that profitability set to materially ramp this year and beyond.

Section 6 -- Rounding Out PayPal’s Merchant-Facing Product Suite

6.1 Hyperwallet

As briefly discussed, Hyperwallet is the pay-out iced tea to Braintree’s pay-in lemonade. The two feature large client overlap and are typically sold as complements to merchants. Pre-Hyperwallet, PayPal had been wonderfully reliable in powering pay-ins all the way to settlement into a merchant’s account. But many of these merchants are aggregated marketplaces with thousands of sellers needing compensation. That’s where Hyperwallet comes in.

This transaction -- which closed 4 years ago for $400 million -- completed PayPal’s vision of building an end-to-end payments suite for merchants and marketplaces. Just like Braintree allows merchants to accept all relevant LPMs to juice confidence and conversion with a single integration, Hyperwallet does the same for compensating sellers. And this compensation all happens within a day. Other competitors often have 3 day holding periods -- and that’s not a regulatory requirement, but a matter of balance sheet needs requiring them to await bank clearing. Hyperwallet fixes this issue and so offers a PayPal-fostered working capital edge for merchants. With marketplaces fiercely competing to attract sellers, paying merchants more quickly and in their preferred method is how these markets win.

To get a sense of marketplace payout preference for Hyperwallet, look no further than Walmart. Its own marketplace implemented Hyperwallet and saw more than 50% of its new sellers -- amid a sea of options -- using Hyperwallet since the recent launch.

Hyperwallet’s CEO Brent Warrington stayed with PayPal post-acquisition -- just like PayPal’s acquired founders generally do.

6.2 Zettle

PayPal bought Zettle, the Stockholm-based technology firm, in 2018 for $2.2 billion in mainly cash. Zettle is the glue allowing PayPal’s customer and merchant bases to connect to brick and mortar settings. This glue is what enables PayPal to facilitate the same payment flexibility, on-site rewards and targeted promotions upon store entrance as it does online. A key part of PayPal’s omni-channel ambitions is channeled into its Zettle POS product offering: It’s how PayPal has married its digital excellence with newfound in-store expertise. Without Zettle and its technology, PayPal would be more limited here.

Zettle began in Europe and Latin American pre-PayPal, but expanded to the United States in 2021 post-M&A. As a side note, the debut timing here was impeccable as it coincided with an explosion in new American business applications post-pandemic shock. Just like Venmo, Zettle paired with PayPal means that it won’t have to start from scratch on international expansion. Instead, it will use PayPal’s established compliance and risk teams to expand in a far more affordable, seamless and likely successful manner. The combination also means that it gains access to all of the benefit-building bolt-on arrows in PayPal’s quiver.

As of last year, roughly 47% of SMBs had no online presence -- even 1+ year into the pandemic where PayPal served as a lifeline to keep businesses afloat. Visa thinks that number is closer to 41%, but regardless, there’s plenty of white space. And that’s the target audience for this segment.

Like a normal POS system, Zettle comes with all of the card readers, QR code features, physical gateway/processor functions and relevant funding source integrations that its competition does -- but it takes things further than some. Zettle’s software is fully equipped with holistic order and inventory management across all channels including 3rd party marketplaces and social media platforms where this is typically more difficult. With it, inventory aggregated from all live selling paths is updated in a live, centralized dashboard to assess demand trends, performance and re-ordering needs. All of this can be taken on the go anywhere with a Wi-Fi connection and the wireless hardware.

That level of automation also supports financial reporting teams by building accurate statements using all of this data. This is an efficiency force multiplier for CFOs.

Where Zettle can’t directly assist, it partners and integrates. Key relationships with QuickBooks, Shopify and so many more create a broader set of interoperable tools and complete operational oversight -- all within the Zettle ecosystem. It’s good to be friendly with industry complements, and Zettle gained those needed relationships with PayPal’s acquisition.

In terms of what’s next for Zettle, the focus is on limiting hardware requirements (and therefore friction) for attracting new merchants. To do so, in May 2022 Zettle launched its softwarePOS (called “softPOS”) in a few European countries to supplement its tap to pay solutions. With the new tool, merchants can offer tap to pay functionality just with an Android device and the Zettle Go app. The founder of Zettle -- Jacob de Geer -- stayed on post transaction along with the rest of his founding team. We love to see it.

6.3 Merchant Card Offerings

a) Credit & Debit:

PayPal features a merchant debit product with 0.5% cash back on all purchases, but the firm has placed far more of a focus on credit for merchants to date.

The organization also offers revolving credit products to fund growth and demand for its merchants. In the United States, it partners with FIs like WebBank to serve as the originating conduit for these loans, and then immediately buys back the receivables to store on its own balance sheet. Abroad, it has that Banking License in Luxembourg (PayPal has no interest in a U.S. bank charter) that allows it to originate. Its European merchant loan book features better margins than in the USA as there’s no originating conduit fees because the license permits PayPal to use 35% of its E.U. balances to issue credit.

In terms of the actual merchant credit products, PayPal has two: PayPal Working Capital (PPWC) and PayPal Business Loans (PPBL). PPWC allows merchants to borrow a set percentage of their total payment volume for a fixed fee. In a world where liquidity and inventory -- especially for SMBs -- are often expansion bottlenecks, this helps significantly. And because of the extensive credit and liquidity data history that PayPal has on each merchant, it can generally offer these loans at “more favorable terms than the alternative” according to leadership. I struggled to find any data quantifying this. This product is available in the U.S. through its FI partnerships, across Europe through its Luxembourg banking entity and in Australia via a partnership with Citi Bank.

PPBL is a more traditional short term loan offering with weekly payment schedules able to be used for working capital needs or any other corporate purposes. The product was obtained through PayPal’s $182 million acquisition of Swift Financial in 2017 which -- to put simply -- was a large underwriting upgrade shot in the arm. According to the company’s CTO -- Sri Shivananda -- this gave PayPal the ability to run dozens more risk models in 0.3 seconds supporting “industry-leading risk loss rates.” Merchant credit success is predicated on finding a compelling balance of risk management and minimal friction -- Swift lets PayPal accomplish that objective. Swift’s President at the time was Doug Bland who today is the Head of PayPal Consumer; another purchased executive still with the company years later.

Like PPWC, PPBL is available through originating conduits in the U.S. and at PayPal’ European Bank across the pond. Furthermore, PayPal also partners with key FIs in Brazil, India and Mexico to extend merchant credit via this format as well. Going forward, PayPal could look to expand into real estate with renter-based merchant credit. It recently invested in a company called Jetty that is working in this very project to accelerate that path.

Most recently, PayPal debuted a new merchant revolving credit card to expand the Cash-Back convenience it can provide to merchants. The Card -- offered through the Mastercard rail and issued by WebBank -- has no fees, and offers 2% cashback on ALL purchases with no rewards maximums. It offers APRs ranging from 13.99%-29.99%, the ability to create more employee cards under the same account, consolidated billing reports, and of course, PayPal’s protection programs. The card comes with a digital twin that is immediately available for use upon approval in the merchant’s account.

Section 7 -- Rounding Out PayPal’s Consumer-Facing Product Suite

7.1 Consumer Credit and Synchrony

PayPal offers accessible consumer credit tools to augment their buying power, flexibility and ultimately contribution to PayPal’s overall volumes. BNPL is a primary example, but as we’ve already covered this we’ll focus on the revolving credit tools here. Similarly to its merchant offering, PayPal uses a partner -- Synchrony Bank -- to serve as the exclusive issuer of PayPal (and Venmo) branded revolving consumer credit cards. This agreement continues through 2028 with the BNPL installment product potentially on the table in the future. The card offers unlimited 3% cash back on all PayPal-checkout purchases with 2% cash back on everything else.

Where this domestic consumer offering differs from the merchant side of the business is that PayPal doesn’t own any of its U.S. consumer receivables -- Synchrony does. A few years ago, PayPal sold its U.S. consumer receivables portfolio to Synchrony for $6.5 billion in total proceeds. It now simply collects fees for issuing new cards through the relationship. This allowed the FinTech firm to become far more asset-light and freed it to focus on delivering great products while Synchrony provided its expertise in managing the credit portfolio. In Europe, PayPal uses its Luxembourg banking entity to originate and holds those loans itself like on the merchant side.

PayPal has dozens of consumer risk underwriting models seasoned with 20+ years of data and trillions upon trillions in transaction volume. As a result, it issues consumer credit at a 30% lower FICO score than alternatives with the same loss profile and generally lower APRs. As a company trying to democratize financial services, this is surely one of the ways that ambition is brought to life.

PayPal is careful to stay well within its limits when it comes to credit issuance. Leadership frequently tells us that it will not let earnings materially deteriorate across credit cycles to a point where it is viewed as a lender and awarded a lower stock multiple. This is merely about juicing the volume passing through PayPal’s system. But this type of volume will not be accepted unless it comes with acceptable life of loan loss rates. No exceptions.

“We’re not a bank or a lender in the U.S. We’re a payments tech company, but this is an important product to drive the flywheel.” -- PayPal Head of Consumer Doug Bland

7.2 Xoom

Xoom is another P2P payments platform but with an international flare. This is a market leader in sending cash, prepaid phones and bill payments cross-border. The service has a ferociously loyal user base boasting a 97% repeat activity rate. Once Xoom gets a customer, the value it provides generally keeps those users around for the longer term.

From PayPal's 2021 Investor Day

Section 8 -- Risks

8.1 eBay

eBay terminated its operating agreement with PayPal which has led a year of wild, unpredictable fluctuations in performance. Interestingly, this event had both positives and negatives -- but I view it as a net positive.

a) The negatives:

First, the material negatives. The agreement’s end led to eBay internalizing a larger portion of its payments process. This meant removing preferential placement treatment for PayPal on the marketplace and switching to Adyen as its primary payments processor. eBay had been paying PayPal a hefty 4% take rate for its end-to-end payments services and knew it could cut costs by switching. Starting last year, eBay began this migration away from the PayPal system it had in place; the impact to PayPal’s near term results has been quite harsh. In 2021 alone, the move erased a full $1 (22%) from PayPal’s earnings per share. The change was also responsible for most of PayPal’s recent take rate compression with its cut from eBay transactions falling from that 4% level to 2.37% today.

Furthermore, the less preferential checkout placement shaved nearly 10% off of PayPal’s 2021 revenue growth as its share on eBay’s marketplace fell sharply. The pain will continue into Q2 2022, but will end in Q3 2022 as YoY comps begin to normalize. For now, the revenue growth headwind in 2022 remains a robust 8% -- although it has fallen from an even more overwhelming 13% during Q2 and Q3 of 2021. The firm is almost through this obstacle and I personally cannot wait to stop qualifying and adjusting growth rates with “ex-eBay.”

Finally, the pace of this migration surprised PayPal in its briskness. That meant a sharper hit to growth than it was anticipating and contributed to its inability to accurately guide forward results over the last few quarters.

b) The positives:

The operating agreement between the two companies explicitly prohibited PayPal from working closely with countless other competing marketplaces. You can imagine that as eBay has faded away, and other marketplaces have stormed onto the scene, this restriction has become a large burden. Those handcuffs are now off.

In anticipation of this expiration, PayPal debuted “PayPal for Marketplaces” in late 2019 to cater its checkout product to marketplace needs with things like Hyperconnect’s easy seller pay-outs to power maximum convenience. The results to date have been stellar.

With PayPal free to serve other markets, it has gained preferential placement contracts with Walmart, brand new relationships with Instacart, Salesforce, Gojek, Oracle, Alibaba, FlutterWave and DoorDash along with countless other material wins. Perhaps the most notable is Venmo’s new Checkout partnership with Amazon which would not have been possible while still aligned with eBay. I repeat: None of this was possible under the eBay operating agreement. And in addition to all of this, PayPal is still maintaining over 50% checkout share with eBay despite it losing special treatment.

MercadoLibre is another global marketplace that the firm was able to cozy-up to. PayPal invested $750 million into the company in 2019 and has a board seat with it as well. This partnership is allowing PayPal to side-step overhead investments in the region and lean on MercadoLibre’s resources to focus on products for their consumers.

Ask yourselves: Would you rather have a higher eBay checkout share and take rate? Or half of eBay’s business and dozens of other relationships to turbocharge long term growth? For context, these marketplaces are growing at roughly 11X the clip that eBay has been for PayPal. To me, the answer is clear: PayPal is better off without the operating agreement.

Since 2017, eBay has fallen from 20% of PayPal’s revenue to now roughly 3% of it and I passionately believe PayPal is a far more balanced company because of it. Still, eBay’s buddy-buddy deal with PayPal did provide a wonderfully visible and high margin chunk of revenue that must be replaced. Signs are positive so far.

8.2 Competition

When a company wants to be a “superapp” within an industry, it essentially opens itself up to competition with everyone -- and that’s the case for PayPal. Competition is robust.

a) FinTech:

Within the world of FinTech, digital wallets are abundant. SoFi offers more yield on savings accounts, Affirm has several compelling BNPL relationships, Zettle’s POS niche is broadly commoditized, Coinbase offers many more crypto currencies and Block’s Cash App product suite is ahead of PayPal’s at this point in time. Firms like Upstart with algorithms to issue credit more effectively than others are also plentiful. No matter where you look, there are dozens of hungry players vying for PayPal’s share. To stand out in this crowded field, PayPal must offer incremental access, convenience and trust. The statistics and studies are all encouraging data points -- but past results do not guarantee future success.

b) Mega-Caps:

It’s not just pure-play fintechs PayPal competes with in financial services, but Apple, Google and other tech giants as well. Many are aggressively building out payments services while leveraging their massive install bases to serve as built-in audiences. With this kind of network and the balance sheets of these firms, competition does not get much stronger. PayPal does offer vendors like Google and Apple through its own payment products through somewhat close partnerships, but this is still a fragile “frenemy” style association in my view. Candidly, I see Apple as PayPal’s most concerning competitor in the United States where the iPhone grip is tightest and then Google in the countries abroad where Android has dominant market share.

Apple specifically has found rapid success in picking up merchant adoption for its own checkout offering, Apple Pay. According to MoffettNathanson, Apple has accumulated 36% of the largest 500 internet retailers in just a few years. This doesn’t mean that they are an exclusive payment provider, merely that they are offered. PayPal rose slightly from 78% to 79% during that time, which is above and beyond the largest, but Apple is quickly catching up. I would point out that the study measured Apple’s penetration rate with Safari merchants specifically (its own engine) while PayPal’s is all merchants, but it’s still quite notable. In the U.S., Visa’s and AmEx’s checkout products actually lost share during this same period along with Google and some smaller players as the market consolidates.

I think it’s all but inevitable that Apple and Google will find success and market share in the payments landscape, and that’s fine. Data indicates that this market share is not coming from PayPal, but from cash transactions and manually entering in card data. Since the start of the pandemic, you’ll recall that PayPal has actually taken another 2% incremental checkout market share, and I expect this to continue as VC-funded cash burners fade into a worsening macro environment. Furthermore, digital wallet usage is not a zero sum game. Usage of Apple’s and Google’s wallets -- perhaps somewhat surprisingly -- actually makes the usage of PayPal’s, Venmo’s and others more likely. It’s apparently a tide that lifts all boats, but PayPal still would obviously like to be the dominant player.

“We’ve seen others gain checkout share but it’s not at our expense. Typing debit or credit into the browser is where that share is coming from. We continue to grow our checkout share.” — Former CFO John Rainey end of 2021

During my conversation with PayPal leadership on this very topic, they explained this phenomenon to me as a parallel to the 1990s. During that time, cards per household soared from 1 to nearly 5 while debit cards were introduced to supposedly kill the credit card. In reality, usage of one card did not mean forgoing the other, and PayPal sees digital wallets in a very similar, higher-tech light.

Perhaps the most important evidence of competitive efficacy is how teens continue to embrace all of these options. They have the longest spend runway and the least amount of time engaged in commerce pre-FinTech. And for both PayPal and Apple, things seem good. Per an extensive U.S. teen survey out of Piper Sandler, Apple Pay is the top payment app among respondents with 23% having the app and being monthly active users. Venmo is at 21% with PayPal at 10% for 31% combined between the two. Cash App is also holding steady at a respectable 15%. Legacy banks and others including Zelle and Google Pay all lag far behind.

It’s imperative to point out that 87% of those polled had an iPhone which obviously makes Apple Pay more likely to have and use. This is encouraging as it shows that even those in the Apple ecosystem are using Venmo and PayPal.

To make things more interesting, Apple Pay recently publicized its intention to launch a BNPL product. Apple has announced a few initial partners for BNPL including Shopify and Block, but not PayPal -- although its widely expected that Venmo and PayPal could eventually become integration partners for the credit offering. Mizuho thinks that could boost Venmo’s 50%+ top line growth by a full 2,000 basis points. Within that same Piper Sandler survey, PayPal is actually the top Pay Later option among teens by a wide margin. It has a 34% penetration rate vs. Afterpay’s 2nd place 30%. PayPal was one of the last movers here and it shot quickly ahead -- but now enter Apple.

And again, in terms of international markets where PayPal participates and Android dominates, Google represents a similar competitive threat.

c) Payments ecosystems:

PayPal’s payment service niche is tolerated by FIs because of the incremental reach, profitability and volume it delivers to them. That’s why PayPal has spent so aggressively and focused so enthusiastically on the digital wallet and its commerce platform: It needs to continue amassing merchants and consumers for it to be a key cog in the payments machine. In a perfect world, merchant acquirers would also be the merchant account and the payment processor -- for no added customer acquisition cost -- while leaving just gateway servicing to PayPal. After all, why would a bank sacrifice a chunk of its take rate if it doesn’t need to do so? It wouldn’t.

This power dynamic manifests in payment servicing fee splits functioning as a constant series of pushes and pulls. Rails have raised their merchant fees for PayPal in the past, which directly makes PayPal less compelling (all else being equal). To complicate things further, regulators have flirted with imposing interchange fee caps in the past which would prompt these rails to pass costs on to others in order to preserve margins. This is again why massive scale is so important: It comes with more volume which coincides with bargaining power. Without this network, that power sinks like quicksand. PayPal also has agreements in place with Visa and Mastercard (and a close relationship with AmEx) to bar any fees targeting PayPal, but these associations are still mightily powerful.

But PayPal doesn’t seem to be suffering at least as of yet. Quite the contrary. For the first time in 20 years, it raised its branded take rate in 2021 from 2.9% + $0.30 to 3.49% + $0.30 for both PayPal’s and Venmo’s checkout offerings to better reflect all of the value creation it orchestrates. It also hiked its fees on all crypto transactions. Considering Venmo’s and PayPal’s crypto share are both in the top 3 (per The Washington Post), pricing power here will undeniably be a material boost. And finally, it also conducted the aforementioned instant transfer price hike. Clearly, it sees its competitive positioning as powerful enough demand a larger chunk of the volume pie. Importantly, all of these hikes were “successful with no discernible impact to merchant activity” according to former CFO John Rainey.

Conversely on the private-label side of things, it changed its un-branded Braintree fee from 2.9% + $0.30 to 2.59% + $0.49 to better compete. Without the PayPal brand, these services become far more commoditized and this change encapsulates that while juicing Braintree’s overall take rate for smaller transactions.

8.3 Macroeconomic Volatility

As a payments company, macroeconomic and consumer health matter dearly to PayPal. Its growth will somewhat tightly track economic activity. Well, that health looks to be quite precarious at this point in time. Atlanta’s FedNow Real GDP survey is pointing to a recession, the Philadelphia Fed Manufacturing Index is at generational lows, corporate high yield credit spreads are widening at an alarming rate, inflation is at generational highs, consumer confidence is near generational lows and layoffs from large caps are daily headlines. Fun times. When you cater predominately to discretionary purchasing, these are real issues. All of this is surely weighing on payment volumes being processed globally, and PayPal is not immune.

Monetary and credit cycles are inevitable. While they’re short term challenges, they also have a way of eliminating weaker competition while allowing the best in breed to take more share over time. That’s how I see PayPal positioned heading into 2023 -- but some don’t agree and that’s really a consequence of PayPal’s failure to model and guide through these difficult times.

a) Pandemic Sugar High

The pandemic was very, very good for PayPal. Yes, the stimulus checks and federal protection loans did hit its credit volumes hard, punished Zettle’s brick and mortar volumes and slowed Braintree’s travel/leisure niche a bit, but the net effect was overwhelmingly good for this company. The two structural tailwinds of cash displacement and e-commerce penetration that influence its growth were both turbo-charged -- and PayPal benefitted as a result. Depending on who you ask, these trends were pulled forward by 3-5 years which propped up PayPal’s growth rates and margins while the pandemic puttered along.

Like many other executive teams during these unpredictable times, PayPal’s has struggled with forecasting Covid-19 trends. PayPal leaned optimistic amid extreme uncertainty which is the ultimate no-no. In a world requiring consistent under-promise and over-deliver, PayPal over-promised on growth. It has even had to lay-off some employees this year to re-focus resources on other parts of the business and to “do fewer things better” in the words of Schulman. It has gone through a series of small restructuring events globally to emphasize fewer international markets -- but this was the first re-structuring event of the cycle that involved domestic employees. It’s worth noting that these layoffs represent a minuscule 1% of PayPal’s workforce and it continues to hire at an exponentially faster clip in other parts of the business. It’s not slowing down, just re-allocating resources.

b) Guiding in a Post-Pandemic World

During PayPal’s 2021 investor day -- when the permanence of pandemic trends was perhaps most convincing -- it offered overly ambitious long term guidance of reaching 750 million total accounts. The company added rosy forecasts of 20% and 22% organic revenue and net income growth respectively through 2025 as well. Considering it organically compounded sales at 16% from 2015-2020, this was very impressive to the analyst community. It was also unattainable.

By the end of 2021, PayPal had removed all of this guidance after it fell short of its estimates across the board. This was following its raising of those expectations consistently throughout early 2021. It got too excited, extrapolating pandemic tendencies as perpetual when they were temporary. This disappointment also included removing 4.5 million fraudulent accounts and a heavier than expected eBay headwind, but was still undeniably underwhelming.

The weakness actually prompted PayPal to embark on a philosophical change from prioritizing account quantity to quality. It found that account creation occurred to abuse cash promotions and incentives rather than consistently transact. After bonuses were paid, the accounts would generally go dormant, leading to negative return on investment (ROI) for the program. Now, the focus is on engagement rather than maximizing users. Through all of this, PayPal’s top of funnel customer acquisition remained robust, but churn rose and led to the account growth miss. That’s why it’s so fixated on creating relevant new use cases: It means lower churn and so more growth.

As briefly alluded to, PayPal’s international focus had been spread too wide and thin according to leadership. It was spending heavily in markets still years away from contributing meaningfully to the business. To address this, it pivoted to focusing on North America, Europe and select parts of other regions while forgoing the lower ROI customers in other countries. It selected more developed markets such as Mexico where PayPal has over 50% adoption share of the 50 largest merchants and Brazil where it partnered with Ipringa to implement a pay at the pump app at its 6500 locations.

Considering 30% of PayPal’s accounts contribute the vast majority of its revenue, this is an appropriate shift. It’s far more lucrative for PayPal to raise engagement and account quality than to pay out cash burning incentives with no return. Still, that message had some fearing a decline in user growth in 2022. Schulman has told us repeatedly that user growth will continue, but the primary aim has evolved for the better.

Unfortunately, PayPal’s inability to accurately guide did not stop in 2021. The company offered its first 2022 guidance in late 2021:

• 18% spot rate revenue growth.

• 20% Total Payment Volume (TPV) growth.

• A 4% eBay growth headwind.

• To exit the year with that 20% and 22% medium term sales and profit growth guide since removed.

• A combination of eBay, a higher tax rate, no stimulus and comping vs. large credit reserve releases in 2021 (explained next section) to shave 10% off of its earnings growth for the year to earn $4.68.

• To add 17.5 million net new active accounts while letting another 17.5 million low engagement users naturally roll off in light of its account philosophy change.

As we moved into the first quarter of this year, that YoY growth rate expectation was lowered by 600 basis points to 12% while the EPS hit from the aforementioned headwinds intensified to lower earnings estimates to $3.87. Its volume growth guide was also lowered from 20.5% to 14% -- yikes. No wonder the stock is 60%+ off all-time highs.

The list of excuses explaining this swing and a miss was long and understandable. E-commerce growth has lately underwhelmed industry-wide expectations, inflation is cutting into discretionary spend, supply chain issues are making advertisers timid and we’re now comping vs. the sugar high that came from stimulus and stay-at-home orders -- 2022 is the hangover. All of this was bundled into a message that the year was off to a “slower than expected start” which prompted the conservative guidance update and leaves me wondering: “Will it fall further?”

My issue with this is not the lackluster 2022 performance. If you look across the landscape at Amazon cutting capacity, Walmart and Target slashing prices and countless other e-commerce players with greatly slowing spend, the pain is clearly macro-based, not specific to PayPal. PayPal also has continued to gain market share through this all which is more explicit evidence of macro being the culprit. It will be a tough year, but it’s equipped better than most to endure with its fortress balance sheet and cash flow.

“We’ve gained share over the last 5 years and that was true for Q1 2022 as well.”  — CEO Dan Schulman

The main problem I have is how management reacted to the unknown with, for lack of a better term, arrogance on its ability to overcome challenges that were insurmountable. Selfishly for me, this is actually what opened the door to start a position and encouragingly, the team has now completely overhauled the way it thinks about guiding:

“We got ahead of ourselves with assuming pandemic trends would continue. We’ve changed the way we guide to operate under the assumption that things get worse, not better. We want to make sure we can deliver or over-deliver." — CEO Dan Schulman in May 2022

That’s music to my ears, but with as many times as PayPal has whiffed on expectations, this now a show me story. As Charlie Munger famously says, a reputation is built over a lifetime and can be lost in a moment. PayPal built a reputation of consistent execution until the pandemic struck, and now it’s up to leadership to re-capture that trust and comfort within the institutional investor community. I’m optimistic that it will, be we shall see.

As of June, Schulman told us that the negative macro hit on PayPal’s business had not worsened since the last Q1 2022 earnings call. Things hadn’t gotten better or worse. Considering how conservative PayPal is telling us its current guidance is, we finally could see some upside risk to results rather than consistent downside risk.

“There are some glimmers of macro hope, but I think we’ve got a long, tough slog for the rest of the year.” — CEO Dan Schulman June 2022

c) Weird Comps For Now

Part of the reason for poor pandemic modeling is surely just how strange YoY comps have been for the last several quarters. The first reason for that strangeness eBay. Starting in Q2 2021, PayPal began measuring eBay’s migration vs. a time in which the operating agreement remained intact. eBay’s volume contribution coincidingly cratered YoY by more than 40% and that comparison will last until the end of June 2022 when PayPal’s results will begin comping eBay contributions that are entirely apples to apples. It also wasn’t up to PayPal how quickly the transition would take place. It was the messenger here and merely communicated eBay’s plans to the investor community. Those plans changed and so the cadence of the impact negatively accelerated as well.

This is one key reason why demand and profit growth is expected to accelerate starting in Q3 2022 -- but not the only reason.

PayPal’s equity portfolio performed historically well from mid-2020 to mid-2021. Rising values in these investments were marked to market on a quarterly basis and propped up net income -- for reference its net income grew by 84% in Q1 2021. Conversely, those equity investments have shriveled in value over the last few quarters. As a result, profit growth comps until Q3 2022 will be very challenged due to the YoY periods measuring against large equity gains. Reason number two for why comps get easier starting in Q3 2022.

But wait, there’s more! In 2020, to respond to the immense insecurity as the pandemic initially struck, PayPal built a large base of credit reserves in anticipation of perhaps needing to use the funds to cover future losses. A weird piece of GAAP accounting is that the building of these reserves actually counts as net loss on the income statement. Well, these losses never came to fruition as monumentally historic government stimulus and aid kept risk artificially low through the thick of the storm.

As a result, PayPal released a large portion (hundreds of millions) of these credit reserves in 2021 -- which counts towards net income -- leading to a $0.23 earnings per share tailwind in Q1 2021 alone. This release of reserves happened most meaningfully through the first six months of 2021, which is reason number three as to why comps get far easier starting in Q3 2022.

The positive e-commerce and cash displacement demand shocks that greatly accelerated PayPal’s growth are now also being lapped simultaneously with all of these other factors. And you guessed it, the toughest YoY comps from this item end in Q3 2022. It won’t be blue skies ahead afterwards, but it will be bluer skies. Just like assuming cruises and travel would return as the pandemic faded away, I take great comfort in assuming e-commerce growth will re-accelerate once YoY periods in question standardize. These trends started long before the pandemic and will last long after it as well.

That positive demand shock was largely related to generous stimulus checks which aided not only demand, but also profit growth. Why? Stimulus greatly propped up the usage of debit for PayPal transactions which comes with lower transaction expenses than credit and thus boosted margins. Again, this impact largely wrapped up in Q2 2021 making things easier starting in Q3 2022 -- for the 5th reason.

Finally, PayPal’s effective tax rate was 11% in 2021 and just 12% in 2020 which were both artificially low. This has reverted higher in 2022 will challenge profit growth further until the end of the year:

All of these temporary issues are weighing on growth and leading to the narrative forming of PayPal being a dinosaur. I would ask people with that opinion to go a level deeper to see why I’m so confident in growth’s re-acceleration into 2023. This last year has absolutely been difficult for PayPal -- and leadership’s guidance complicated things further. Still, I think all of these reasons paired with the company’s continued ability to take market share will lead to an abrupt change in the narrative as we work our way through 2022. Obviously, I could always be wrong and there will likely be more macro-related turbulence involved before we get there.

8.4 Regulation

Regulation is a risk for every company in the payments space. The CFPB, and in PayPal’s case the European Central Bank (ECB) and Luxembourg equivalent (CSSF), all closely monitor the behaviors of these companies to ensure proper behavior. That will not change. But for PayPal specifically, its regulatory focus and clout makes this less of a concern than nearly every other player in the industry -- aside from the Bank of America’s of the World. There are three key regulatory scenarios to focus on as concerns for PayPal shareholders. First, is the aforementioned interchange fee cap that has garnered little momentum in congress.

Next, the legality of PayPal’s domestic merchant credit business model has been consistently challenged by regulators in the past. As briefly covered, it’s structured so that banking partners originate the credit and immediately sell the receivables back to PayPal to store on its balance sheet for collection of net interest income. That procedure gives PayPal the same state tax exemptions and cost of capital advantages enjoyed by charted banks while not having the actual licensing to get these incentives on its own. Many have termed this “renting a charter” and State Attorneys General have consistently challenged this maneuver to try and block it from taking place. In the last 2 years, the FDIC and OCC have both re-affirmed the legality of renting a charter, but things could always change.

One more potential regulatory thorn in PayPal’s side is changing tax reporting rules for P2P services like Venmo and PayPal (and others). Starting in 2022, the IRS changed its reporting requirements for payments funneled through third party networks (through a form called a 1099-K). Pre-2022, businesses did not have to fill this out and pay the coinciding income tax unless payments eclipsed $20,000 in total value. That minimum was cut to $600 this year to tighten the disclosure grips on these digital payment networks. While this has been a pain in the neck for PayPal’s digital wallets and led to a brief user blip, that engagement has since fully recovered. Further strictness here would theoretically impact engagement over the short term again for PayPal and all other players in the space. Notably, this only covers payments to businesses and does not include peer to peer payments between friends for settling up costs on a ball game or meal.

8.5 M&A

Integrating M&A successfully is no simple task. Whether it be Teladoc’s inability to integrate Livongo, Lululemon swinging and missing on its Mirror Acquisition or Constellation having to write down essentially their entire Canopy Growth purchase, effectively combining organizations is complicated. And with as frequently as PayPal purchases other entities, this must be considered by investors. The company reviews 1000+ potential takeover targets annually and that will not change. Luckily, PayPal’s track record of fruitful integration and acquired executive teams remaining on is encouraging.

Furthermore, this risk is less concerning to me than it would have been two years ago before PayPal removed its formal M&A guidance. If it has the cash and the ability to build internally, why accept the integration risks associated with M&A? Because even for PayPal and its strong history, it hasn’t been perfect. In 2017, it bought TIO Networks to accelerate its foray into Bill Pay. Just months later, this was shut down by regulators due to TIO sharing sensitive personal information from its 1.6 million users. Not great. Still, the positive examples far outnumber the negatives and that’s heartening to me.

What’s even more heartening to me is how CEO Dan Schulman openly discusses PayPal’s M&A plans. According to him, PayPal has very little interest in conducting “transformative M&A” or buying anything that would be dilutive to PayPal for several years. Its purchases will likely be bolt-on services to enhance a capability or add some new talent rather than to make a blockbuster jump. This philosophy has served it well while it has seen other competitors make ill-advised mammoth purchases of BNPL players like AfterPay. It also did not get far in its Pinterest acquisition process despite what financial media news outlets reported on the matter -- that’s music to my ears.

“Regardless of some public companies having valuations that are disconnected from reality, so be it. We have our view and we will stick with it.” — CEO Dan Schulman Late 2021

While the company has noticeably slowed its M&A tempo and leaned more heavily into internal organic development, that could once again be evolving. Per my conversations with leadership, the shellacked FinTech multiples we’ve seen industry-wide could open the door for PayPal getting more aggressive with scooping up more assets on sale. It has a large net cash position, strong balance sheet and consistent cash flow generation which all put it in an enviable position for M&A as bargains appear.

“Ironically, this is one of the times when PayPal can do the best in the market because of our checkout advantages and business model. In a year that will not be our best, we’ll still generate $5 billion in free cash flow and we’re still investing in our business while other major competitors are retrenching… this is a chance to double down and take advantage of our strengths.” — CEO Dan Schulman June 2022

Section 9 -- The Team, The Team, The Team

9.1 The Team

Prior to joining PayPal in 2015, Schulman racked up some notable experience as the President of Enterprise Growth with AmEx, the President of Prepaid at Sprint, the CEO of Virgin Mobile and Priceline.com and finally the former Consumer President at AT&T. Today, he also sits on Verizon’s Board.

He boasts a strong 86% Glassdoor rating, which is higher than any other CEO I’ve seen with over 5,000 reviews, and has a sterling reputation as a capable leader of this emerging blue chip. From an equity perspective, however, the loud swings and misses (plural) on guidance in consecutive quarters took his reputation in the investment community down a few notches. I’m confident these feelings will wain as all of PayPal’s exogenous headwinds abate and this industry finds its groove again. PayPal has a great opportunity ahead of it to emerge healthier, and that would make Schulman an investor darling once more. We’ll see.

Overly ambitious guidance also wasn’t predominately on Schulman, but on former CFO John Rainey who recently left for the same position at Walmart. While leadership attrition is never preferred, it did not bother me all that much here as Rainey’s finance department was responsible for the overly optimistic forecasts that PayPal’s stock has paid so dearly for. Today, Gabrielle Rabinovitch is the Interim CFO and the search for a permanent replacement is well underway.

9.2 Culture & Workforce

PayPal runs an annual global workforce survey gauging satisfaction and intentions. As of December 2021, employee propensity to recommend the company to a peer (similar to an NPS) sat at a robust 83% vs. 80% in 2019. 2021 was also its lowest employee attrition year on record, although that rate is likely rising in 2022 as it has for countless other companies when stock compensation packages crater in value. Still, average employee tenure is over 3 years, which is quite strong for a company like this one.

Interestingly, PayPal’s rock solid liquidity and profits position it well to scoop up newly available talent from other companies. With layoffs becoming a cliché in the world of FinTech, the company is ready to pounce:

“With stock prices disrupted, there’s a lot of talent up for grabs. People are looking for the stable market leaders who will emerge stronger and we are in that position.” — CEO Dan Schulman in May 2022

Frequent workplace accolades from Forbes, Fortune and Glassdoor are all more signs of a strong company culture. But while those are nice, it’s really a lack of management red flags that I seek out in companies as “strong culture” is difficult to quantify. PayPal’s team showcases this lack of red flags.

9.3 Highlights from the latest Proxy Statement

Vanguard owns 8.01% of the company which rose slightly YoY while BlackRock owns 6.5% which shrank slightly YoY. As is usually the case with firms that have cycled through many leadership teams, PayPal’s executives all own less than 1% of the company outright. Schulman has seen his stake rise slightly YoY along with most other executives besides the departing Rainey.

This rise has been due to PayPal’s compensation practices as it liberally uses performance-based restricted stock units (PBRSUs). These restricted shares are rewarded based on success within three key performance indicators -- revenue, operating margin and account growth. For Schulman specifically, his calculations entail a 2X multiplier which means he gets double the payback for the same level of performance on a year to year basis. Other executives have a 1.25X multiplier. The payout for 2021 was just 60% of the target as results underwhelmed -- and to me it’s encouraging to see leadership struggling (relatively speaking) alongside shareholders amid poor results. Incentives are largely aligned. Finally, there are also PBRSUs awarded based on longer term targets like 3-year compounded annual growth rate (CAGR) benchmarks being eclipsed.

So far in 2022, there has been one open-market sale of stock by Peggy Alford for a little over $1 million while there have also been 6 open-market purchases eclipsing $4 million. Schulman chipped in with a nearly $1 million buy (out of his $200 million fortune) himself.

Finally, this month (July 2022), activist investing firm Elliott Management disclosed a stake in PayPal. The size of the stake and Elliott’s plans have not been shared yet with the public, but that is certainly something to keep an eye on.

Section 10 -- Results & Prospects

10.1 Costs and Margins

PayPal’s costs can be split into two main buckets -- transaction-related and everything else.

a) Transaction Expenses and Margin

Transaction expenses are largely variable (headcount involved is somewhat fixed) as they’re correlated with PayPal’s payment volume. For a non-payments company, this expense classification would be similar to variable input costs and could be roughly compared to contribution margins. Transaction expenses are the disbursement fees owed to issuers, acquirers and any other party involved in a payment process that PayPal uses to facilitate a transaction.

A second piece of this bucket is referred to as transaction and loan or credit losses. These are the costs PayPal incurs from operating its protection programs as well as any losses associated with its merchant credit receivables and consumer receivables outside of the USA. This is also where those aforementioned losses/gains associated with building/releasing credit reserves is realized.

A few key Transaction Expense-related terms to know:

• Transaction Margin = Revenue - Transaction Expense - Transaction losses

• Transaction Expense Rate = Transaction expense / TPV

• Transaction and Credit Loss Rate = Transaction and credit losses / TPV

• Transaction Take Rate = Transaction revenue / TPV

b) Transaction Unit Economics Tailwinds and Headwinds

There are a few tailwinds and headwinds to talk about for transaction unit economics. Again, PayPal’s take rate has consistently fallen over the last several years as the business has evolved -- and that is expected to continue. This is the main margin headwind.

It’s important to note that aside from eBay, PayPal’s take rates on a product by product basis are not falling. As we saw with checkout and Venmo Crypto, the trend of PayPal’s fees is higher. So then what’s going on? About 55% of the take rate decline over the last several quarters has been eBay-related and will stop impacting PayPal starting in Q3 2022. Beyond that, the proliferation of Braintree, Bill Pay and Venmo P2P all come with lower take rates and round out the remaining 45% of the fall. With Venmo specifically, the rise of its commerce offerings should be a significantly positive offset. This came to fruition last quarter with Venmo’s revenue growth rate at 5X its volume growth rate. Venmo offers a slight reprieve from the take rate decline, but the long term trend remains lower.

Cross-border transactions also boast a higher take rate for PayPal as its FX conversion services garner an additional fee of 3%-4% depending on transaction type. As a result of the pandemic and major supply chain issues, that lucrative segment has fallen from 17% of total PayPal volume to 14% which has hit take rate to a certain extent. If that were to revert as things like Chinese port re-openings play out, it could be a nice compression counterbalance.

What am I getting at here? Take rate is an important piece of PayPal’s margin profile, but the two are not that closely correlated. When excluding the positive margin impact of the pandemic, the company has seen margins largely stable at elevated levels over the long haul while this take rate compression has taken place:

And that combination of margin sustainability paired with take rate contraction is expected to endure with things like organizational cost structure improvement offering relief. Specifically, PayPal expects about 8-10 bps of take rate compression annually through 2025 implying a slowing, yet consistent rate of decline.

Schulman’s aforementioned re-vamping of PayPal’s technology stack and fraud/risk capabilities with Simility came with falling transaction losses, another benefit of the tech modernization. Its newfound ability to create data cohesion across product teams is paying dividends. More transactions and data mean more seasoned ML algorithms and better loss rates on an apples to apples basis. This transaction and credit loss rate may rise in the short term with the vastly worsening macro-backdrop, but the long term trend should remain lower.

Transaction expense rate is where the pandemic makes things a bit weird. The vast amount of government stimulus flowed through to digital commerce. And when it did, it flowed via debit and ACH which materially pushed PayPal’s transaction margin higher on a temporary basis. Higher margins meant more temporary profit dollars in Q1/Q2 2021 and difficult comps for Q1 and Q2 2022. That has since stabilized as pandemic-era tailwinds faded away, consumer savings levels sank to decade lows, credit demand spiked and volume based expenses coincidingly returned back from 42% of sales to 49%.

In terms of the long term transaction expense trend, it should be largely stable with some positive risk. Why? As discussed, CBDC propagation (a form of cash displacement) comes with relatively strong PayPal margins vs. 3rd party funding. BNPL could provide another small bit of help to transaction expense rate with its 85% debit/ACH funding rate. The last thing to keep in mind here is that although Bill Pay and P2P have lower transaction take rates, they also come with lower transaction expense rates which is just another reason why take rate compression to come does not mean future margin compression.

c) Non-Transaction Operating Expenses

Non-Transaction expenses are every other cost PayPal incurs -- from company overhead to computing servers to marketing campaigns. This is where PayPal has enjoyed the bulk of its operating leverage durability as these costs are not nearly as variable as transaction costs and so don’t directly float with more volume.

Deducting both transaction and non-transaction related expenses from revenue leaves us with operating margin -- my favorite profit metric to use for this firm specifically. Items below the operating income line such as violent fluctuations in equity investment values and tax rates can make net income fluctuate to a point where it’s not all that relevant of a statistic. For context, other income was $279 million in 2019, $1.78 billion in 2020 and a loss of $163 million in 2021 via non-operating factors that greatly impacted net income -- but not operating income. Operating income takes out this noise.

NI = Net Income

As we can see above, the items propping up transaction margin from Q2 2020 to Q2 2021 did the same for operating and net income margins. Conversely, free cash flow margin was a bit less impacted as large credit reserve fluctuations have no influence on this financial statement:

FCF = Free Cash Flow

Non-transaction-related expenses is where developing internally vs. buying shows up in the financials. The forgone M&A has predominately been spent on operating expenses and R&D instead. That’s why this cost item as a whole has grown well north of 15% for the last several quarters -- significantly above the historical rate.

Heavy investments to capture the opportunity associated with demand pull forwards contributed as well. Candidly, PayPal leadership admits that this expansion wasn’t nearly as efficient as it should’ve been due to the rapid pace of growth. Now, it’s right-sizing those investments to ensure it can continue to economically grow in the most profitable way possible and pursue opportunities while returning significant cash to shareholders. The team expects growth here to fall below 10% going forward which would mean margin expansion to come.

In terms of return on invested capital (ROIC), PayPal has been able to deliver respectable clips to shareholders for several years in a row. It should, however, be noted that 2021 ROIC got a boost from an abnormally low effective tax rate:

ROIC = (Operating Income - Tax)/(Debt + Equity)

d) Incremental Margin Commentary

PayPal occasionally offers incremental margin commentary (margins on new revenue) which all points to continued margin maintenance and perhaps some expansion. For example, last year it disclosed its incremental operating and free cash flow margins at 28% and 25% respectively. Leadership frequently tells us that “margins want to go up” which really just means the company expects to get more out of its fixed cost base over time as new investments slow.

For now, PayPal’s bias is to invest that next dollar in any compelling ROI opportunity it sees rather than dropping it to the bottom line. As we can see, its margins are still quite strong regardless, which points to the mouth-watering unit economics inherent in the model.

10.2 Demand

PayPal has been consistently and strongly compounding its top line metrics for several years. Since its first full year as a public company post eBay spin-off, it has compounded sales at a roughly 20% clip with that rate actually accelerating above 20% from 2019-2021. The pandemic was a perfect storm of growth for PayPal, and to its credit it took advantage which we can see in the 2-year CAGR charts vs. the 5-year:

TPA = Transactions per Account

You may be curious as to why TPA didn’t get the same pandemic boost as the other metrics. That was actually a matter of outperforming net new account growth as PayPal’s new users generally debut at engagement troughs and build from there. Because these new cohorts were a larger portion of total accounts than they’d been in the past, that served as an engagement headwind. Encouragingly, TPA momentum is beginning to show up as of last quarter with the metric briskly ticking up to 47.0. That result represents 11.3% growth which includes a several percent growth hit from eBay and is still PayPal’s fastest rate of expansion in a long time.

When looking at more recent trends, the same phenomenon of a fantastic Q2 2020 - Q2 2021 creating difficult comps through Q2 2022 holds true:

10.3 Balance Sheet

As of PayPal’s most debt issuance in May 2022, it had roughly $11 billion in total debt, a tad over $17 billion in cash, equivalents and investments and an expectation to comfortably surpass $5 billion in free cash flow this year. Most of PayPal’s existing debt was issued between 2019 and 2020 with rates between 2.2%-3.3% and maturities from 2022 to 2050. This May, PayPal issued new debt at rates ranging from 4.4% to 5.25% and maturities from 2032-2062. This came with slightly less favorable terms than previous issuances as macro chaos and rising rates lead lenders to demand more.

Of this $3 billion, about $1.1 billion was used to pay down existing debt with the rest added to the balance sheet. It performs capital raises like this every few years to kick the proverbial debt maturity cans down the road and to bolster its firepower to invest and buyback shares. And speaking of buybacks, the pace of PayPal’s share re-purchases has noticeably accelerated over the last 5 quarters:

Note that buybacks have more than offset stock based compensation since 2016, and so share count has shrunk.

Section 11 -- Expectations and Plan

11.1 Expectations

Here, I’ll lay out five compounding scenarios for PayPal to offer a rough framework of where I think the stock can go from here. It’s vital to highlight that these are rough estimates and should be taken with a grain of salt. The number of educated guesses inherent in a five-year forecast is large and so the accuracy will rarely be precise. Furthermore, I tried to err on the side of pessimistic with my assumptions to build a margin of safety and account for PayPal’s fragile performance since mid-way through 2021:

11.2 Plan

PayPal is currently 4.8% of my portfolio with my cost basis at roughly $107 per share. I’ve used the last several months of price volatility to meticulously and intentionally build out my position in the company that is roughly 88% full at this point in time. With macroeconomic headlines as consistently negative as they’ve been recently, I’ll be very careful deploying that remaining 12% as I don’t expect the FinTech space to bounce back as quickly as some are hoping. We could be in for some turbulent chop as generational low consumer confidence, rising rates and diminishing liquidity all weigh on commerce transaction volume.

As we overcome all of the macro headwinds, I view PayPal as a high quality enterprise that will rise and thrive when the global economy emerges from this tightening cycle. Still, this company is on a somewhat shorter leash than I normally deploy as a result of its last several quarters of performance. My bullishness in PayPal is strong, but not unconditional. Schulman, the ball is in your court to hopefully keep me in as a shareholder in the years to come. We shall see how things play out.

Thank you for reading!