With a market cap nearing $125 billion, PayPal Holdings (NASDAQ: PYPL) is one of the largest payments companies in the world and one of the most exciting tech stocks on Wall Street. The company facilitated 9.9 billion transactions worth $578 billion in total payment volume in 2018. The company has a history of using fintech to solve some of the thorniest issues with moving money in the digital age, and a list of its former employees reads like a who's who of Silicon Valley. And despite its meteoric rise since being spun off from eBay (NASDAQ: EBAY) in the summer of 2015, an investment in PayPal's shares still seems to stand a better-than-decent chance of beating the S&P 500 index going forward.
Let's look closely at PayPal's business model, including its core platform and its many offshoots such as Braintree, Venmo, and Xoom, and examine why the company is poised to benefit from major changes rooted in consumer behavior and technological advancements, along with its growing network effect. By the end of the article, I will craft a bullish case for investing in PayPal, from its growth and valuation to the economic moats that provide its competitive advantages. But before we get into all of that, let's take a look at the company's history, which is filled with more twists and turns than an M. Night Shyamalan movie.
PayPal is a digital payments pioneer that survived countless rivals in its early days to become one of the world's largest digital payments platforms. Image source: PayPal Holdings.
Peter Thiel was a fledgling hedge fund manager with a law degree from Stanford and a diverse background that included stints as a speechwriter for former Secretary of Education William Bennett and a derivatives trader for Credit Suisse. Max Levchin was a University of Illinois graduate with a knack for coding and a passion for entrepreneurship. While he was still a boy, his parents fled on foot, with Max and his brother in tow, from the Chernobyl nuclear disaster site in their Soviet Union homeland.
While living in California, Levchin was urged by a friend to attend a speech Thiel was giving at Stanford University. Only a few people showed up, giving Levchin and Thiel time to interact. The two hit it off so well that Thiel recommended they get together the next day. Over breakfast, Thiel told Levchin that he would invest in one of Levchin's ideas for a start-up: Confinity, a company that would develop encryption and security for handheld devices, enabling the digital transfer of money. Just a few weeks later, both agreed it would stand a greater chance of success if Thiel joined the company as its CEO.
PayPal's first business model
Thiel and Levchin soon realized that encryption standards on mobile devices would only work if applications were built that could actually use these standards. The company's small team then decided to focus on building these applications -- specifically, a platform that would allow users to transfer money using Palm Pilots, the most popular mobile device at the time. This platform would be called PayPal. This Wired article from 1999 quaintly sets the scene, where Confinity received much-needed funds that were "beamed" to it from a venture capital firm interested in the company's technology.
Fortunately, the PayPal team soon realized the platform, as it was presently construed, would not work: Not nearly enough people had a Palm Pilot-type device to make the platform useful. As PayPal's former executive vice president, Reid Hoffman, aptly pointed out, not even in Silicon Valley, the technology capital of the world, did an entire random group of diners sharing a table at a restaurant all own Palm Pilots, effectively ending this experiment.
After brainstorming, the team eventually landed on the idea of transferring money via email. By the late 1990s, a majority of the American public was already using email to communicate, giving the new PayPal platform plenty of potential users and a large total addressable market (TAM). This final pivot ultimately propelled PayPal to success.
Elon Musk and PayPal
After PayPal enabled money transfers with email, the platform took off, specifically with buyers and sellers on the new e-commerce platform eBay, where users had struggled to find ways to efficiently buy and sell items. In those early days of the internet, accepting credit cards was an arduous task for merchants, especially smaller ones, and a shopping experience based on mailing checks was painfully slow. Almost overnight, PayPal changed that process.
In March 2000, PayPal merged with another fintech start-up, X.com, which was actively experimenting with online banking applications. X.com CEO Elon Musk took over the reins of the newly combined company, but friction soon arose over which legacy company's products were being prioritized. The two companies' cultures also clashed, causing tension among the ranks and leading to Thiel's resignation. Soon after the merger, however, Musk asked that the PayPal application be built on a Microsoft platform rather than UNIX, causing a revolt among PayPal's programmers.
When Musk left for a long-overdue vacation, he was fired, and Thiel was brought back as the CEO. Years later, while reminiscing about the turn of events, Musk would half-joke, "That's the problem with vacations."
How eBay helped PayPal grow
Despite the dysfunction behind the scenes, PayPal was adding users at an exponential rate. From January to August 2000, PayPal's accounts jumped from 12,000 to 2.7 million, a 224,000% increase. The jump in user accounts was fueled by a smart marketing campaign that promised to reward new users with $10 in their accounts. Users who referred new members would also receive $10. This promotional campaign, combined with PayPal's rapid adoption among eBay's buyers and sellers, propelled PayPal's explosion in growth.
By the end of this period, the successes of PayPal and eBay were completely intertwined. By October 2000, 25% of all transactions facilitated across eBay's site used PayPal to pay for the purchase. About five times as many sellers were accepting PayPal as a method of payment as were accepting Billpoint, eBay's own payment method. Competitors such as Billpoint, Citigroup's C2It, and Western Union's MoneyZap kept trying to capture market share in this new space, but all comers proved unsuccessful.
By this point, PayPal owed some of its success to charging lower fees than its competitors. Its larger advantage, however, stemmed from a budding network effect across eBay's shopping platform. The more buyers and sellers who joined its service, the more valuable its network became.
PayPal's IPO and purchase by eBay
Image source: eBay.
While its marketing campaign was working brilliantly in growing PayPal's user base, it was also burning through the company's cash at a rapid rate. To solve the problem, PayPal's management decided to take the company public. In September 2001, just weeks after 9/11 and still in the wake of the disastrous dot-com tech bubble bursting, the company announced it would be holding an IPO.
Soon after going public, PayPal agreed to be acquired by eBay for $1.5 billion. The acquisition forever solved PayPal's money woes and quelled PayPal management's growing fears that eBay would ban PayPal from its site. (Though the move would have caused an uproar among eBay's merchants and customers, it was an existential threat hanging over PayPal's head.)
In purchasing PayPal, eBay finally waved the white flag. For years, the company had tried to kick PayPal off its platform by heavily promoting its own proprietary payments platform and restricting PayPal's use. All those efforts came to naught.
How PayPal's innovations changed the internet
PayPal debuted many new features that we now take for granted, solving many of the initial pain points of the internet and e-commerce.
One of PayPal's greatest contributions to the early days of online commerce was how it dealt with the massive amounts of fraud that accompanied its explosive growth. In fact, at one point, the company was suffering $2,300 in fraudulent losses per hour. Levchin developed two methods to fight this fraud that are now used practically everywhere:
- Levchin created an algorithm, which he nicknamed Igor after a Russian hacker in the habit of taunting the company, to flag activity that was characteristic of fraudulent actions.
- Levchin also developed CAPTCHA technology, where human users must type the random characters appearing in a box to prove that they are not bots with fake accounts.
Combined, the two techniques stopped fraudulent losses in their tracks. These moves undoubtedly helped PayPal secure trust with consumers in the early days of e-commerce.
PayPal's early iteration was also one of the first viral apps, allowing users to send money to people without an account; recipients were forced to open an account to claim their money. It was essentially the first real app built on top of a larger platform (eBay), and the PayPal logo was the first embeddable image for Web pages, allowing sellers to embed it in their eBay listings.
How PayPal alumni succeeded in tech
PayPal's team was welcomed into eBay's family with a three-hour PowerPoint presentation, signaling to longtime PayPal employees that the two cultures would quickly clash. In a TechRepublic interview, former PayPal executive vice president Keith Rabois said:
I remember sitting in the integration meeting with eBay. So, this is as we are figuring out how to align the teams and prioritize roadmaps. And the eBay team arrived with a 137-page PowerPoint. And, they proceeded to try to walk David Sacks, and me, and a couple of my colleagues through this PowerPoint slide by slide. As soon as the meeting started, I remember to this day, thinking, "there's no way in the world this is going to work." David [Sacks] immediately started flipping ahead like 20 to 30 pages and the eBay team was mortified that someone wasn't waiting for them to narrate slide by slide for a three-hour meeting. In the history of PayPal, there has never been a three-hour meeting, period; and they started off the integration meeting with a three-hour time block.
PayPal's team would soon hit the exit doors. But far from retiring with riches to luxurious tropical beaches, most early PayPal executives stayed in Silicon Valley, investing in and founding some of the world's most exciting tech companies. These Hall of Fame-worthy entrepreneurs became known as the "PayPal mafia." Here is just a sample of these luminaries and the companies they either founded or invested in extremely early in their life cycles.
|PayPal Mafia Member(s)||Company||Result|
|Reid Hoffman, PayPal executive vice president||Acquired by Microsoft (NASDAQ: MSFT) in 2016 for $26.2 billion|
|Steve Chen, PayPal engineer; Chad Hurley, PayPal web designer; Jawed Karim, PayPal engineer||YouTube||Acquired by Alphabet in 2006 for $1.65 billion|
|Elon Musk, founder of X.com||SpaceX||Private, approximate value of $25 billion|
|Elon Musk, founder of X.com||Tesla ||Public, approximate $51.5 billion market cap|
|Peter Thiel, PayPal founder and CEO||Palantir||Private, approximate value of $6 billion|
|David Sacks, PayPal COO||Yammer||Acquired by Microsoft in 2012 for $1.2 billion|
|Jeremy Stoppelman, PayPal vice president of technology; Max Levchin, PayPal founder and chief technology officer; Russel Simmons, PayPal engineer||Yelp ||Public, approximate market cap of $4.15 billion|
The eBay Years, 2002-2015
While part of eBay, PayPal made several acquisitions to beef up its capabilities and security features. By 2010, PayPal had surpassed 100 million active members in almost 200 markets, but it wasn't until 2013, when eBay acquired Braintree for $800 million, that PayPal's future trajectory was significantly impacted. Braintree provides online and mobile payment processing services to e-commerce merchants.
While Braintree is still what PayPal uses to service payment processing needs of online merchants, PayPal scored two other major dynamics with this acquisition: Braintree's CEO Bill Ready, PayPal's current COO, and Venmo, a mobile P2P payments solution especially popular with millennials for its social element.
In January 2014, activist investor Carl Icahn established a stake in eBay and began calling for the company to spin off PayPal, a move he believed would unlock value for both companies. After conducting a "strategic review," eBay management released a prepared statement stating the company had approved a plan to separate the eBay and PayPal businesses from each other. Then-CEO John Donahoe stated: "The industry landscape is changing, and each business faces different competitive opportunities and challenges. eBay and PayPal will be sharper and stronger, and more focused and competitive as leading, stand-alone companies in their respective markets."
PayPal's payment partners
In July 2015, eBay and PayPal officially parted ways. Soon after PayPal went independent, competition in the payments market got heated, with the credit card networks, especially, seeing the newly independent payments platform as a growing threat. In May 2016, former Visa (NYSE: V) CEO Charles Scharf expressed his displeasure with PayPal for attempting to disintermediate consumers' relationships with their banks and credit cards at an investor conference. He stated if PayPal's actions didn't change, the card network would put all of its resources into going after PayPal.
Specifically, Scharf alleged that PayPal was attempting to capture consumers' transactions in any way possible, whether payment was being made via credit or debit cards or ACH payments (electronic bank transfers). However, once PayPal won the consumer's account, it would push these customers to make transactions with ACH payments, a much more profitable transaction for PayPal. Scharf was also upset that the data on cardholders' purchases were being kept from the card network. While using less pointed language, Mastercard executives expressed similar concerns.
A few months later, PayPal announced a landmark PayPal-Visa partnership. As part of the deal, PayPal agreed to share data with Visa and to no longer encourage Visa cardholders to switch to ACH payments. Visa gave PayPal access to Visa's token and digital network in the U.S., where contactless payments were accepted, giving PayPal footing in the point-of-sale (POS) retail world.
Despite good quarterly numbers, PayPal's stock tumbled on the news, with some investors believing PayPal had caved to the card networks' demands and threats. A number of similar new deals followed, however, and PayPal CEO Dan Schulman consistently stated the deals were necessary for PayPal to act as a "customer champion," allowing customers to pay with whatever means they wanted for every single transaction. This opened more doors for PayPal, specifically into the physical retail world, giving its account holders opportunities to use the platform everywhere: online, in-app, and at the POS.
How PayPal's stock succeeded
Wall Street reacted negatively to PayPal's initial deal with Visa. But as the company continued to post solid quarterly numbers with rising revenue, earnings, active customer accounts, and user engagement, the market started to come around. From the time PayPal was spun off from eBay to the end of 2016, a period of almost 18 months, PayPal's stock price meandered itself to a 7.5% gain.
As 2017 progressed, PayPal announced dozens of new deals, and the market finally began to appreciate the unique position the newly independent payments platform found itself in. It was the only digital wallet that was not beholden to a mobile operating system, such as Alphabet's (NASDAQ: GOOGL) (NASDAQ: GOOG) Google Pay; a smartphone manufacturer, such as Apple's (NASDAQ: AAPL) Apple Pay; a specific bank, such as JPMorgan Chase's (NYSE: JPM) Chase Pay; or a merchant or marketplace, such as Amazon.com's (NASDAQ: AMZN) Amazon Payments or Walmart's (NYSE: WMT) Walmart Pay.
In the company's 2017 Q2, Schulman touted its neutral positioning: "We are an open platform and a suite of services, both branded and unbranded, that's operating system- and device and technology-agnostic. And so...very importantly, we're a neutral third-party platform."
PayPal's competitive advantages
Why did active accounts and user engagement accelerate at such high rates? The answer has to do with the network effect we mentioned earlier -- a type of economic moat. The more PayPal consumer accounts there are, the more merchants will want to accept PayPal as a method of payment, and the more merchants that accept PayPal, the more attractive a PayPal account will be to consumers.
When PayPal first separated from eBay in July 2015, the company boasted 169 million active users growing at an 11% year-over-year rate. As of early 2019, PayPal's active users exceeded 277 million, including 22 million merchant accounts and more than 40 million Venmo accounts. Since its separation, PayPal has grown active users by 64% and projects to exceed 300 million active user accounts by the end of 2019.
Another secret sauce to PayPal capturing so much growth, especially in respect to mobile payment volume, is its One Touch platform. One Touch is a feature that allows users to pay with just "one touch" from a registered device. In other words, when enrolled users make an online purchase from participating merchants, they do not need to enter cumbersome data such as their name, shipping and billing addresses, credit card numbers, etc. All that is required is to click the PayPal button once. From personal experience, I can categorically say that this comes in especially handy when trying to shop with fat fingers on a small smartphone screen.
The macro forces fueling PayPal's growth
Two macro trends, e-commerce and mobile commerce, are also driving PayPal's outsized growth. These trends are at the intersection of technology and consumer behavior and have completely revolutionized retail over the past two decades. It doesn't take a rocket scientist to see how quickly consumers have adapted to making online purchases. Ditto for shopping with their smartphones. The numbers back these observations up as well.
In 2018, e-commerce sales rose 14.2% year over year, while total retail sales only increased 4.8%, according to the U.S. Department of Commerce. That trend has stayed consistent for several years. In Total Systems' 2017 U.S. Consumer Payment Study, 51% expressed an interest in making a purchase using their smartphone, up from just 39% in 2015.
PayPal's mobile payment volume, payments originating from a mobile device, represented 41% of PayPal's total payment volume by the end of 2018.
What other platforms does PayPal own?
PayPal offers more for investors than just its core platform services, including:
Braintree: Braintree services allow merchants to accept payments via mobile and in-app. One of its most prolific customers is the ridesharing service Uber. When Uber first expanded into Paris, it charged riders in U.S. dollars but displayed Euros onscreen. This obviously caused a lot of frustration among customers, and the service failed to gain traction for quite a while. After Uber switched to Braintree, this huge headache disappeared. As Braintree's website proclaims: "Braintree processes payments in over 130 currencies around the world, so Uber's international passengers were able to begin making payments in their local currencies from day one. Braintree's technology is simple enough to be integrated in just 20 minutes."
iZettle: The largest of PayPal's acquisitions since its eBay days, iZettle -- informally known as the "Square (NYSE: SQ) of Europe" -- is a payment processing company servicing small European merchants. As a stand-alone company, iZettle processed about $6 billion in payment volume and generated about $165 million in revenue in the year leading up to its acquisition. More importantly, however, the move gave PayPal a legitimate POS solution for small merchants and a foothold in several key European markets.
Paydiant: Acquired in 2015 just before the eBay separation, Paydiant offers retailers white-label mobile wallet and loyalty capabilities. Its biggest customers include Capital One Financial and the Subway restaurant chain.
Venmo: Acquired in the Braintree acquisition in 2013, Venmo is largely a mobile P2P payments platform with a social media twist. In 2018's Q2, Venmo's payment volume grew to $14.2 billion, a 78% increase year over year. Venmo's popularity with millennials and its rapid growth have led its management team to experiment with monetizing Venmo. Managers have introduced a debit card linked to Venmo accounts and introduced Pay with Venmo, a platform that allows users to make transactions with their Venmo accounts at participating merchants.
Xoom allows users to send international remittance payments digitally, giving users a much cheaper option than traditional remittance services. Image source: PayPal Holdings.
Xoom: Xoom is an international remittance platform acquired by PayPal in 2015 that allows users to make digital cross-border payments. The international remittance industry, the act of migrant workers working in a foreign country sending money to their homeland, is huge, with an estimated $574 billion in payment volume in 2016. The average cost of a digital international money transfer using Xoom is only 3.93% of the total amount, compared to the average cost of remittance of 7.45%. Xoom plays a significant role in PayPal's goal to provide key financial services for the world's underbanked population.
One of Wall Street's most exciting tech stocks
PayPal Holdings makes for an enticing investment on several different levels. Given PayPal's growing network effect, its strong positioning in mobile payments, its dominant One Touch platform, its many different payment platforms extending into different areas of the market, and its strong and consistent revenue and earnings growth, PayPal's stock looks poised to deliver more market-beating returns to investors for years to come.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Matthew Cochrane owns shares of Alphabet (A shares), Amazon, JPMorgan Chase, Mastercard, Microsoft, PayPal Holdings, and Square. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Mastercard, PayPal Holdings, Square, and Tesla. The Motley Fool owns shares of Visa and has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and short January 2019 $80 calls on Square. The Motley Fool recommends eBay and Yelp. The Motley Fool has a disclosure policy.