Both PayPal (NASDAQ:PYPL) and Block (NYSE:SQ) have lost nearly 80% from their all-time highs, but while this represents a buying opportunity for PayPal I do not think it is the same for Block. Given an adverse future economic environment, the capital-economic strength of a company is a crucial aspect to avoid risking worse-than-market returns.
PayPal currently has a much more dominant position than Block in the payment industry as well as a free cash flow (2021) almost 8 times higher. While it is true that Block has more interesting growth prospects being a smaller company overall, it does not have a market capitalization so distant from that of PayPal as to justify the current economic/equity differences.
Using a discounted cash flow, it follows that PayPal is rather undervalued while Block still remains overvalued despite the sharp slump, which is why my rating is a buy for PayPal and sell for Block.
PayPal’s revenues are more resilient
In a macroeconomic scenario where the FED raises interest rates and economic growth slows down, we need to be very selective in choosing our investments otherwise the risk of suffering a large loss is high. It is no longer the time to invest in high-growth speculative companies as their prospects become increasingly gray. Some of them have reached reasonable prices, but others may collapse further. Profitable companies with a strong competitive advantage are the only certainty, and PayPal certainly fits this description; however, I have my doubts for Block.
Comparing the income growth of the two companies, the rapid improvement of Block, which has increased its revenues much faster than PayPal, immediately stands out. But what can be said about net income? Operating expenses and the cost of goods sold have increased in tandem with revenues, thus, the company’s profitability remains very low. PayPal’s growth, on the other hand, has been slower but at the same time more steady and solid, proving to be more of a value company than a growth company. During a recession, a company that makes money will always be viewed better than one that does not.
In a recessionary environment it is essential to make profits to fuel the company’s economic activity, but it seems that Block is not headed down that path. The cost of debt is rising sharply after rising interest rates and obtaining new capital by issuing new shares may not be as successful as in the past. Block used to dilute its shareholders to make new investments but now we are no longer in the midst of a bubble where anyone is willing to buy any stock at any price.
Even for free cash flow the trend is on PayPal’s side: a positive year (2021) does not make Block a solid company. At this point a question arises: if PayPal is such a solid company, then why did it lose 80% from its all-time high just like Block? The reason is that both companies had reached excessively high prices but now the market is finally punishing this speculation. However, if for Block this collapse was deserved for PayPal it was not (or at least not to this extent) and this is what I will want to demonstrate in this article.
In this first part we have seen how PayPal’s 2021 free cash flow is almost 8 times larger than Block’s, but this strong divergence is not present in the market cap: Block capitalizes $37.5 billion while PayPal $85.5 billion. This is a large gap but still does not justify such different profitability in my opinion. Block’s main problem is not its revenue growth, but how much of that revenue turns into profit. Excluding operating costs that may be deliberately high due to variable costs, Block has too high cost of sales that heavily reduces final margins.
In 2021 Block almost doubled its revenues, but at the same time it also doubled its cost of goods sold. In 2021, the cost of goods sold was almost the same for these two companies, but PayPal had $7.7 billion more in revenues.
Last but not least, it is important to understand the difference in the quality of Block’s and PayPal’s revenues.
From Block’s annual report we can easily notice that in 2021 as much as $10 billion was earned through Bitcoin trading within Cash App. I personally think it is good that Block wants to make Cash App more than just a payment app, but I do not think this is the most sustainable way. 2021 was a roaring year for the entire cryptocurrency world, but I doubt Block can earn another $10 billion this year in this way. Getting more than half of the revenue from trading a speculative “asset” is certainly not what I mean by a solid business model. I may be biased since I am certainly not an admirer of cryptos, but I challenge anyone to argue that last year’s euphoria has not faded. In Q1 2022 Block issued no guidance update, which makes me think that Q2 2022 revenues will be much lower because of a sharp reduction in crypto trading.
PayPal’s revenues have grown more slowly but are certainly more resilient in the event of a recession. 92.2% comes from transaction revenues, which are net transaction fees charged primarily to merchants on a per transaction basis. In this segment, we also find gains related to cryptocurrency exchange here, but this is by no means comparable to Block. Although PayPal has not officially stated how much it has earned through crypto trading it is conceivable that this could be a much lower percentage than Block’s 56%. PayPal’s move into cryptocurrencies did not occur until late 2020, so only in the last quarter cryptocurrencies impacted 2020 revenues: assuming 2021 crypto trading revenues of $3 billion this would still be a percentage exposure about 5 times lower than Block’s.
Market share and CAGR of market segments
Although PayPal and Block pursue the same goal of improving payment efficiency, the market segments in which they operate most are different. Block has a competitive advantage toward the PoS market, while PayPal toward the payment processing solutions market.
- A PoS system aims to track sales, accept payments, create receipts, and more.
- A payment processor, on the other hand, is a service that communicates transaction information between the merchant, the issuing bank, and the acquiring bank.
The BNPL (buy now pay later) market segment in which both companies are investing heavily will also be discussed at the end of this section.
Point of sale (PoS) market
This market was valued at $22 billion in 2021 and is expected to reach $70.75 billion by 2029 (CAGR 15.9%). This is a high-growth market segment and Block is currently positioned much better than PayPal. Block through its Square PoS has a market share of 27.44%, the highest among its competitors. Contrary to popular belief, however, the Square segment accounts for less than 1/3 of Block’s revenues, precisely 29.4%.
I consider this the best segment of Block’s business model even considering the growth forecast, so it is crucial that it can maintain such a high market share.
But what is PayPal doing to compete in this area? In late 2018, iZettle was purchased for $2.2 billion, a Swedish company already embedded within this market. Then in October 2021 Zettle Terminal was launched to compete against Square’s PoS, however it is still too early to tell if PayPal can grab market share through it. I expect improvements in this area for PayPal in the coming years, but currently there is no doubt that it is inferior to Block.
Payment processing solutions market
This market was estimated at $90.9 billion in 2022 and is expected to reach $147.4 billion by 2027 (CAGR 10.1%). This is an overall more mature segment and consequently has a lower growth rate. Within this segment PayPal has a dominant market share of 44.21%, which by the way does not include other payment apps also belonging to PayPal. In this sector, which is far more relevant than the previous one in terms of value, Block is far behind. Its Cash App does not hold a candle to it, and the reason is because most customers do not use it as a payment method or deposit tool, but as a platform in which to exchange bitcoins.
Of the $12.3 billion earned in 2021, 81.7% came from bitcoin trading, about $10 billion. This is the main reason why Cash app is not comparable to PayPal, whose earnings come almost entirely from net transaction fees. With bitcoin 75% far from the all-time high of late 2021 what are the chances that Cash App will have better performance this year? I would say very few.
Block is obviously aware of this dependence of Cash App on Bitcoin and in fact within the annual report warned its shareholders about it. “App customers, increase in the number of business accounts, broader macroeconomic recovery, and from government stimulus and relief programs in place in 2021. These relief programs provided government aid and unemployment benefits which resulted in an increase in consumer spending and inflows into our Cash App ecosystem. Cash App revenue growth may not be sustained at the same levels in future periods and may be impacted by the enactment of further stimulus relief and benefit programs, as well as the demand and market prices for bitcoin, amongst other factors.” In the current uncertain environment in which the so-called “flight to quality” is taking place, I don’t see how this segment of Block cannot get worse this year.
Buy now pay later market
This market segment is having success especially in recent years and has a very impressive growth rate. Currently, neither company has a clear advantage over the other, but it will be interesting to see how this will evolve as both PayPal and Block are investing billions of dollars. This market was valued at $15.91 billion in 2021 and is expected to reach $90.51 billion by 2029 (CAGR 21.7%).
Starting with PayPal, with the introduction of PayPal Monthly the service has been improved by extending the payment time up to 24 months for a product costing $199 to $10,000. The main investment in this market came with the acquisition of Paidy for $2.7 billion in late 2021, a Japanese platform pioneering BNPL solutions. The first results related to this investment may arise in the coming months.
As for Block, on the other hand, the situation is more complex as the company believes much more in this market segment. In November 2021, Square’s shareholders approved the issuance of new shares for the $29 billion purchase of Afterpay. Afterpay is a leading company in the BNPL segment in Australia and is looking to expand its operations by operating through the Block ecosystem. I personally fully agree with the choice made by the company, as this increases exposure to a high-growth sector, but I do not understand why Afterpay was valued so highly. Here are the company’s financials at the time of the acquisition.
Revenues were certainly growing but the company was running at a heavy loss. Obviously from a newly formed growth company we could not expect anything different, but the price is the problem with this transaction: Block bought the company valuing it at A$126.21 per share.
It is evident from Afterpay’s graph that this company experienced speculation that it would cease sooner or later. From the time of the acquisition agreement in August 2021 the company basically lost 50% of its value until January 2022. From then on, it was no longer possible to trade its shares (acquisition completed by Block), but it is very likely that this stock would have continued its descent inexorably given the turn it took this year. Before the pandemic, this stock was trading at A$40 per share and I consider it very likely that it would be at an even lower price today if it were still trading on the market. It could be that Block’s management did not think it was likely to be financed by issuing shares in the following months, but in any case, Afterpay was paid through the nose. In the first two months of 2022 it turned over only $130 million, too little for what it was paid. As of today, Block capitalizes $37.5 billion after making a $29 billion acquisition at the end of 2021: not a great deal so far.
Finally, from a purely practical point of view, what is the most convenient service for a customer? The answer is PayPal, and for two reasons:
- PayPal has access to more than 200 countries, while Afterpay has access to only 5 (UK, US, Canada, Australia, and New Zealand)
- Both services have no interest charges if installments are paid on time. If this does not happen, however, a late fee must be paid, and Afterpay charges more than PayPal.
More info about PayPal
Often when people talk about PayPal, they do not consider the company but only its core business. However, PayPal is much more than that and often makes new acquisitions in order to have a complete exposure to the entire payments system. There are many companies involved, but in this section, I will discuss the ones I find most interesting: Venmo and Honey.
Venmo is a mobile payment service that was acquired in 2013 when PayPal bought Braintree for $800 million: at that time Venmo belonged to Braintree. In the US Venmo is already very popular unlike in Europe, but its popularity is growing more and more. There were 70 million active users in 2021 compared to 52 million in 2020, while the total payment volume in 2021 was $230 billion compared to $159 billion in 2020. Block in 2021 presented a total payment volume of $167 billion; thus, it is lower even than only Venmo under this aspect. If we then considered PayPal in its entirety, the payment volume in 2021 was $1.25 trillion. But why is Venmo becoming so popular? Its popularity is due to the fact that it is not only a payment service but also a social network: through Venmo people can post the purchases they make and also the money they exchange. In 2021 Venmo had sales of as much as $850 million, so I would say it is a successful investment whose margin for growth is still high.
Honey is a company known for its browser extension that encourages online discounts on eCommerce sites at the time of purchase. In 2019 there were 17 million active Honey users and during that year it helped people save a total of $1 billion. Honey was purchased for $4 billion in 2019, but how does this company make money since its service is free? Its only source of income is sales commissions that are received directly from the seller who will also see the discount provided by Honey deducted from the sale of the good. As well as Honey many other companies are purchased by PayPal but are put on the back burner. In this article I have discussed these two, but Braintree, iZettle, Paidy are also worthy of attention. PayPal is not only a mobile payment service, but an entire ecosystem concerning online payments.
Fair value and final considerations
Every investment is the present value of future cash flows, so I will use a discounted cash flow to understand how much PayPal and di Block are worth.
PayPal’s discounted cash flow will be constructed as follows:
- The cost of equity is 9.75%, obtained with a beta of 1.43, country market risk premium of 4.20%, risk free rate of 3.50% and additional risks of 0.25%. The cost of debt is 4.98%. The resulting WACC is 9% and considers a capital structure consisting of 85% equity and 15% debt.
- The company expects revenue growth of 11-13% in 2022 but I preferred not to include double-digit growth to be more conservative. For the first 5 years I assumed 8% growth and for the next 5 years 6% growth. I hardly think these growth rates will turn out to be lower than expected.
- The total outstanding shares and net debt belong to TIKR Terminal.
According to my assumptions PayPal has a fair value of $103.09 per share, so it is currently quite undervalued. Considering also a 30% margin of safety PayPal still looks like a good deal. An 80% drop for a company like PayPal is an opportunity to be seized since we are talking about an already established company and a leader in its industry. Furthermore, I would like to reiterate that the fair value was obtained by including growth rates that are easily achievable by PayPal when we consider that past growth rates have been far higher. Since the company has 429 million active users and a payment volume exceeding one trillion it would have been unrealistic to enter double-digit growth rates, but this should not overshadow the dominant position this company has achieved over the years. PayPal’s 80% collapse is not comparable to Block’s 80% collapse as we will see in a moment. Finally, I would like to point out that the 80% collapse may not be the bottom. No one can predict the future, but at these prices it is undoubtedly a good deal regardless of whether it might collapse another 10% or 20%. In case it reaches even $50 per share, I don’t see where the problem is: there is the opportunity to buy a world-class company at an even more discounted price. In this case it is important to build the position over time.
Block’s discounted cash flow will be constructed as follows:
- The cost of equity is 14.25%, obtained with a beta of 2.42, country market risk premium of 4.20%, risk free rate of 3.50% and additional risks of 0.25%. The cost of debt is 7.65%. The resulting WACC is 13.25% and considers a capital structure consisting of 85% equity and 15% debt.
- The growth rates entered are 30% for the first 5 years and 15% for the following 5. I am sure many of you were expecting higher growth rates, but personally I think the ones entered are already too high. If Cash App generated $12.3 billion in 2021 it is because there was a speculative bubble on cryptocurrencies that led many people to invest in it and as a result this benefited the company’s coffers tremendously. 81.7% of Cash App’s revenues come from bitcoin trading, and I doubt the percentage will be that high in this difficult 2022. With inflation near double digits and a likely recession just around the corner I doubt that investing in bitcoin will be as common as it was in 2021.
- The outstanding shares and net debt belong to TIKR Terminal.
According to my assumptions, Block’s fair value is $46.89 per share, so the company is overvalued. The 80% collapse was not enough, and I do not think a collapse to March 2020 levels (about $40 per share) is unlikely. The volatility of the company and its riskiness have rather negatively affected the fair value. Following this result, however, I would not want it to be understood that my overall thinking about Block is negative, because it is not. Beyond the revenues from bitcoin trading, both Cash App and Square PoS have manifested a high growth rate over the past 2 years, which is why I included that 30% for the next 5 years. I don’t think Block is a future-less company, but I think it is worthwhile if purchased at a reasonable price. There is no doubt that between PayPal and Block the latter is the company with the most risk, therefore, it is necessary to include a higher cost of equity. In addition, the current macroeconomic scenario does not benefit Block as well as all other “growth” companies. Interest rates are rising higher and higher, so it will be more difficult to finance future projects as well as more difficult to finance through issuing new shares. If PayPal needs to make an investment it does not need to dilute its shareholders to raise capital, it simply has the liquidity to do so since it has a stronger business. Block since 2012 has only 2 times had positive operating income and has consistently diluted its shareholders year after year, as happened recently with the acquisition of After Pay.