PayPal Holdings, Inc. (PYPL) Earnings Call Transcript & Summary

Welcome back to Evercore ISI's Payments and Fintech Innovators Forum. I'm David Togut, payments analyst for Evercore ISI. Delighted to welcome John Rainey, Chief Financial Officer and EVP, Customer Operations for PayPal. John, thanks so much for being here. Greatly appreciate it.

It's great to be here, David. Thank you.

At your recent Investor Day, you provided a new 5-year financial guidance, driven by 15% compound annual net new account growth and 20% compound annual organic revenue growth. What will be the biggest drivers of net new account growth and of the 5% growth in ARPU?

Sure. So we were excited to announce the plans over the next 5 years of doubling our net new actives. And a significant driver of that is actually reducing the churn of the existing customers that we have. In any given year, we do -- we have a significant customer, significant number of customers that churn. And part of the launching the new experiences of new products like buy now, pay later, crypto, getting into financial services, is to provide more means of engagement for that customer base so that they're interacting with us on a much more frequent basis, and then for -- more likely to use us in payments and not churn. So a big driver of that increase is reduced churn. I guess, secondarily to that, we've got some plans to grow in particular international markets, which also includes expanding Venmo internationally. So those are probably the 2 big drivers of the net new active growth. From an ARPU perspective, our average revenue per user perspective, similar to my comments on increasing engagement, if we can get those customers that are interacting with us, kind of on a medium engagement level and move them up to high engaged customers, that's going to account for about 2/3 of the revenue increase. And so there's a maturity curve with any new customer, where when they start using PayPal for the first time, it's a little less frequent and then it evolves into something more. And as we roll out more of these experiences, it gives our customers more opportunities to use us. One example I'll give, David, is that with Buy Now Pay Later, 40% of the customers in the U.S. that used that in the fourth quarter actually used it 2 subsequent times. And so it's just -- it's one example of another product that has some stickiness to it that keeps those customers engaged.

Your new 5-year guidance calls for 22% average annual earnings per share growth. What are the biggest drivers of operating margin expansion? Or is some of the 2 percentage point premium of EPS growth over revenue growth likely to come from share repurchase?

Yes. So we've been real pleased with how we've performed thus far from a margin expansion perspective. I think if you go back to 2018 and look at the guidance that we've laid out during that period of time, we've expanded margins, I believe, over 300 basis points. And even our guidance this year -- a year of very heavy internal investment, contemplates 50 to 100 basis points of margin expansion. And so as we look out over the next few years, we think that our ability to continue to scale at that low marginal cost is going to drive increased margin expansion. It's actually not, David, that related to share buyback. We've got plans to buy back shares that are about offsetting the dilution from share-based compensation. We can obviously adjust that moving forward, depending upon what the alternative uses of cash are, where our stock price is and things like that. But really, the margin expansion is just coming from the inherent scalability of the business. As I said before, like our margins want to go up. But we also think it's appropriate to continue to invest heavily so that the next time we've got an Investor Day, and we're talking about the next 5 years after that, we can continue to show this level of growth. And I think that we're fairly rare in the fintech space in so far as being able to enjoy this level of revenue growth and do it while having the margins that we do and importantly, the cash generation that we do.

Where do you expect to see that greater incremental margin, more at the transaction level or the other OpEx level?

I think some of both. So clearly, this year, we've seen some really strong performance in the transaction margin level and grown that more so than any year prior. And that's a function of a lot of things. I think the, sort of, need and relevance of PayPal that exists today as e-commerce has been pulled forward. It's also a function of some of our variable costs, namely transaction expense and transaction loss. We've seen a shift to debit as part of the mix of funding instruments. And the PayPal core branded payment button tends to skew to a lower funding cost. And so as we expect these trends to be sustainable and durable around more online shopping, that's going to mute some of the increase or mute some of the inflation that one might expect over time in transaction expense. On transaction loss, I think we have performed better from a risk perspective than ever in our history. And happy to talk more about that later, but we continue to see, sort of, record lows in our transaction loss as a rate of TPV. And so I think that those will both continue to perform. But at the same time, you see the non-transaction-related expenses, we call it -- everything else or other operating expenses, that we're keeping a check and growing in that kind of mid- to high-single digits. And even then, that includes a lot of investment in the business. So the trends that we've seen there over the last year, I think, are fairly representative of what we'll see going forward.

Where do you think you can take transaction loss to over the 5-year forecast period?

Tough to say, but I clearly think that there's more room for improvement. This is like -- we benefit so much from the amount of data that we have, something like 500 petabytes of data, which is just a ridiculous amount. And with each one of those, we get -- we learn more, we get more sophisticated. And the number of checks that we run on any given transaction goes into the hundreds. And we certainly think that there's always going to be some amount of fraud losses or transaction losses that we're not able to control, letting bad actors in occasionally. But we've done a better job than any point in our history. And a lot of that is improved sophistication around AI and machine learning and what we're doing in these areas. And so I think if you look back on our history here, we're -- we've had about 1.5 years or 2 years of this level of performance. And I think there's still room to improve as we go forward.

You called out the strength in debit that you've seen during the COVID period, and the impact to transaction margin. Obviously, the rollout of crypto as a funding instrument in PayPal Wallet likely will help margin as well. How should we think about the impact of crypto on transaction margin? Is this going to be a high-frequency funding instrument in your view?

It's a good question. And it's probably a little early on to postulate around what this could be in the near term. But as you think about the impact on our margins, the way that we account for that, first, is on a net basis. So we don't account for it on a gross basis like some others do. And we charge basically a transaction fee, which is on a sliding scale, depending upon the size of the transaction. And there's a small spread between the buyer and sellers of that crypto. So that's what we recognize from a revenue perspective. From a cost perspective, we do pay a fee to our partner, Paxos, related to this. And then whatever the customer uses to purchase that, be it a debit card or ACH or credit card, we have the transaction costs associated with that. But I think the real appeal here, getting to your question is, if this is used as a fungible currency for customers to go shop at our merchants of 30 million around the world, and that's really promising because that carries an extremely low transaction expense for us. And so it's one of those many things, even pointing to like Venmo and the increased usage of that with Pay with Venmo that are going to mute some of the pressures that we see around transaction expense.

Staying on crypto for a minute, what does the economic model look like for cryptocurrency trading on Venmo? And for paying with cryptocurrency trading through the PayPal Wallet versus using it as a funding instrument?

Yes. So Venmo will be the same as PayPal, where we'll have that small fee that we charge users to purchase crypto. And there is a spread that we monetize as well between the buy and the sell there. And so that's the revenue element and the expense element is, again, the -- what the fee that we pay Paxos, which is relatively small as well as any cost of the funding instrument. And so it's -- I think important to recognize because we account for it that way, it doesn't represent any outsized volatility on our P&L, given that it's on a net basis. And so we've been though, very excited to see the early adoption of this. And I think really important, David, to our thesis going forward around the increased level of engagement is what we're seeing early on in crypto. And so 2 data points around that. We shared this at Investor Day, but I think it bears repeating. But 50% of those customers that have bought crypto are going to the app daily to log in and check things out. And those -- all of those customers are logging in at twice the rate that an average for what they were before buying crypto. And so it's validating to us to see that when we add these type of experiences, like crypto, like Buy Now, Pay Later and other things like that, we get higher levels of engagement. And that's exactly what we're trying to drive to as we want to become a -- people are using the term super app, but a destination app where people are coming all the time. And there's an interesting figure that I just saw through a report that McKinsey put out that said that 80% of customers engage more frequently with their banking app than they do buy things on Amazon. And I think we all like buying things on Amazon. It can be a daily event in some households. But it shows like that -- the opportunity that's there to really drive that engagement, particularly when we're providing alternative services that get into things like shopping and commerce and other financial services, investing and things like that. So we're quite excited about the impact that all of these things could have on our P&L over the next 5 years.

Is there a way to gauge those users that are logging in to the app daily, half of the crypto users, in terms of what's the flow-through to the PayPal Wallet or Venmo? Can you see a material uplift in both of those products?

We do. We do. And we shared some data around this with our Buy Now, Pay Later, where we see an increase in overall TPV of customers that are using that. And so there's a real synergistic effect to providing additional products that increase the level of engagement overall. And this really goes to, I think, the heart of what we're doing in the offline space around QR, QR code, or just contactless payments in general. Because while the economics of that are not as attractive as what they are online, importantly for us though, if someone is using us in an offline setting then they're a lot more likely to use us online when we -- the economics are a lot more attractive. And then an example I'll point back to is in one of our markets, Germany, where we've got tap-and-pay enabled. We see an incremental 52 transactions online from PayPal users that are using this offline. And so that's an enormous increase in the level of engagement. And it really goes to like what we're trying to drive to around being an every day sort of part of their financial lives.

This accelerating shift toward debit that we've seen through COVID, when you look out at the 5-year forecast period that you provided, how are you thinking about the growth of debit through that forecast period relative to your other major funding instruments?

Yes. So we certainly saw an uptick in the percentage of funding that was done through debit versus credit and other means right after the initial stimulus that was provided in the -- whatever it was, the April time frame last year. And it remained elevated through the year even as we got into December. Not elevated at the same level as what we saw when stimulus checks were out there. But I also think aside from stimulus checks, there appears to be sort of a shift to owed money versus owned money in these periods of trepidation or uncertainty around the economy. And so as we look out, like at 2021 in anticipation of further stimulus, we expect debit to remain at elevated levels. And one might argue that, that's ephemeral. And okay, when we get back to a normal economic environment and the government is not writing stimulus checks for people all the time, will that recalibrate back down. Arguably, so to some level, by the same token, to the extent that we see a greater proportion of the core PayPal-branded experiences being used versus what we refer to as unbranded or the more, sort of, credit card processing. Well, that carries a lower funding instrument or lower mix of funding cost for us. They skew more towards debit, ACH, balance. And so I think that, that's going to keep our funding cost, our transaction expense as a rate of TPV at more depressed levels compared to where we were prior to the pandemic.

You highlighted for this year that 75% of your non-transaction expense growth would be on discretionary investment spending. What are your top 3 priorities for spending on new growth initiatives this year? And do those top 3 spending priorities change as we move into 2022 and beyond?

Yes. I would say that the top 3, and it's really kind of 2.5 because one is encapsulated in the other. But I would say that consumer financial services certainly is a priority as we expand out into additional experiences and capabilities in the wallet. Venmo is one. And again, like these -- what we're doing in financial services, we want to roll out into Venmo and PayPal as well. And then I would say that the QR code is part of that as well. And again, QR code, one could sort of include in some -- there's some overlap with those other two. But I think it's important that we want to provide these omni-type capabilities to the wallet, where you're not just using it online, you have the build to use it offline. You're seeing increased usage of P2P with Venmo. We want to continue to expand things like Pay with Venmo. Certainly, the business profiles, which we've rolled out and are ramping up where Venmo merchants can disaggregate their personal lives from whatever their line of work is, all these things that I think, give us a lot of opportunities to go out and really put the foot on the accelerator on what we can do with Venmo. But those would be the 3 that I would probably call out the most: Financial services, Venmo and then offline or QR code payments.

Does that change as we move into 2022 and beyond?

I think it does. And importantly, like what we laid out at Investor Day and highlighting 4 or 5 incremental experiences, it's not as if when we're finished with that, that, okay, we can wash our hands and we're done. We've got to continue to follow the customer. And I think, it's important to note that a big part of our -- or a big belief that we have over the next few years is this gravitation towards the digital wallet. And whether that means the death of cash or whatever, that remains to be seen when that happens. But certainly, as you complement existing payments with things like being able to pay with rewards or drop or wish list with Commerce and Honey, and roll out with other experiences, having that all in one wallet, I think, is pretty important. And so like -- if you look at Asia, as an example, the number is 40% of in-store payments in Asia are done with a digital wallet. And I would suggest that there's still a lot of opportunity. There's still a lot of addressable market in Asia. But in the U.S., that number is less than 10%. And so when we think about where we're going from here, we want to continue to build out those capabilities in the digital wallet. They're the most pertinent to the customer, most relevant to the customers. And again, there's a belief that we have in the privacy of the digital wallet going forward. I just -- I've said this multiple times, David. But like there's nothing about cash that is better than a digital wallet. I mean, outside of maybe the tactile feel of holding a crisp $20 bill. But everything else about a digital wallet, it's just much easier, simpler, it's more secure. And so I certainly think that we're going to continue to see what we're already seeing in more -- in markets like China, where that's -- they're actually ahead of the rest of the world.

You mentioned QR codes a little earlier, and you've signed a number of large national merchants for QR codes. In the example of CVS, for example, if I'm using my PayPal QR code at CVS, are you bypassing the existing physical merchant acquirer at the point of sale? Or is there some sharing of unit economics?

On the specifics of that, I think it depends merchant by merchant. But we are -- we're more -- think of just like a traditional model there, where there are others that are sharing in some of the economics. But again, like the theme for us in the offline world is not so much the huge appeal of the unit economics on a particular transaction, but it's what it can do to drive further engagement where we really do have better economics and can monetize that much more. So it's very much an engagement play.

You highlighted the accelerating shift to the PayPal Wallet-branded transactions during COVID. As you look over the next 12 months or so, do you think this heightened level of growth in PayPal Wallet-branded transactions will continue?

I -- we do expect that it will be certainly higher than where we were prior to the pandemic. But if you look at whether it's revenue or TPV growth, the way the year unfolds is -- I mean, it's kind of lumpy because of what we're lapping last year. So our highest growth will clearly be in the first quarter, absent something unforeseen right now. And then as we get into the second quarter, there is more challenging comps because that was the peak of the shelter in place, the pantry packing and everyone sort of having this alarmist reaction and purchasing everything online. And so that will be our -- we anticipate our lowest quarter of growth. In the back half of the year, we reaccelerate and get to what is really a more normalized trajectory of growth rates, because the comp is more similar to it's -- the back half of last year where it was, I think, more normalized. And so both from an investment perspective as well as what we anticipate on the revenue side, I think the back half of the year is more representative of what we would expect going forward.

You've guided for Venmo revenue this year to approach $900 million. What are the top drivers of Venmo monetization this year, at least getting the incremental revenue? And is there a specific time line to profitability for Venmo?

Sure. Well, like the rest of our products, what's really appealing about Venmo is the diversified portfolio of products. And historically, we've been pretty reliant on 1 or 2 or 3 different avenues for monetizing that with the predominance being the instant cash withdrawal. Going forward, there are a lot more ways that a customer can use us and also that we can monetize that. Pay with Venmo is going to ramp up a lot more in the second half of this year, and so we're quite excited about that. And look, longer term, that should be one of the key drivers of the revenue and income that we get from that. But I mentioned business profiles. That's another thing that we're quite excited about. QR code is something else. And as -- remember, a lot of the Venmo experiences are shared in a physical setting. And so I think that really plays to that platform. And then we've got the launch of the new credit card, which I truly believe is a model for how future credit card issuances will be when you've integrated that into the app and you have this great experience. And so that's the composition of the various monetization streams that we're anticipating right now. In terms of profitability, we said that this year, we expect roughly $900 million in overall revenue from Venmo, and to be roughly breakeven on a transaction margin basis. As we move into 2022, continue to scale that, continue to grow that, that's the year that we would expect Venmo to be marginally profitable.

Just coming back to capital allocation for a minute, you've guided to $40 billion of total free cash generation over the next 5 years and 30% to 40% of that toward share buyback. When we look at the other 60% to 70%, how do you think about capital allocation priorities? And are there specific areas that you're interested in making acquisitions?

Sure. Well, the -- I guess I'll start with our guidance didn't include any assumptions around growth or income from any of our acquisitions. And that was a contrast to what we did in the prior Investor Day. But the bigger we get, the harder it is to kind of affect those numbers. But I think importantly, as we look out into the next 5 years, we're still going to be very balanced in the way that we allocate capital. We've earmarked 30% to 40%, as we've said, for share buyback. That could vacillate up or down depending upon a number of factors. Importantly, what we see in the M&A space. It's not as if we've got any less appetite for M&A, but we weren't so prescriptive as to say, like we did before, that it's $1 billion to $3 billion annually. We've got, I think, the luxury of being very disciplined and opportunistic. And there isn't this glaring need to go out and address some deficiency in our platform. And so as we think about the type of opportunities that we'll look at going forward, it's, again, building on some of these capabilities, whether it's in the crypto space or financial services, all of these things that provide additional experiences to our customers and address white space around the globe. And the way that I've characterized our growth, David, over the last 5 years has really been more about increasing distribution of our mark out there. And the next 5 years, I think, will be slightly different, and it's improving and increasing experiences. And so it stands to reason that if that's where our focus is over the next 5 years, that some of the M&A that we may do may fall into that line. But I think equally important is we want to invest in the business. And part of investing in the business is also funding credit. And Buy Now, Pay Later is a great example of where we can go out and fund short duration credit that bears pretty minimal risk for us, and drives outsized revenue relative to the capital that's involved -- relative to other, like revolving credit or even the merchant-lending space. The thing about the Buy Now, Pay Later is most of these customers that are coming to us are existing PayPal customers. Most customers, I should say, that are using Buy Now, Pay Later right now are PayPal customers. And so we have a history of their transactions or their credit worthiness. And so the underwriting risk there is very, very small. And that's why I say like when you think about the value proposition here, we've got an easy integration with an existing merchant base. We offer up almost 400 million customers around the world that can use this without anything that they have to do at all. Just -- it's presented there in the wallet. And there's no risk to this, to the merchant and no fees to the consumer, necessarily, late fees, but no cost, no credit cost to that. And then we're charging a price that you can't beat, free. And so I just -- and look, I think our numbers in the fourth quarter, well, it's only one quarter of data. But to be at a point where we're generating $3 billion of annualized TPV in the first quarter in only 3 markets when we've got 3 million customers using this, I think when you consider the opportunities worldwide with our $30 million merchants, it's enormous. Look, Pay Later products in Australia today, which really had a head start on the rest of the world, they represent 8% of e-commerce. And so I'm not suggesting that it's going to be that way globally. But if it's even half of that, it's a huge opportunity for someone like us that I think has a clear distinction in the value proposition in the space.

That's a good segue into the development of the super apps with payment shopping and financial services. What are the major milestones we should watch for in the next, let's say, 12 to 24 months in terms of the development of the super app? Is there anything transformational that might be coming?

So from an investor perspective, I think keeping a close eye on engagement is an indicator of the success here, because a lot of these experiences in the super app, destination app, whatever we want to call it, are really towards driving some of that. And we'll begin rolling out those additional experiences this year. But when we look at everything that's contemplated around this, the suite of options, this is an 18- to 24-month rollout from where we are right now. And so there will be a continued, sort of, cycle of new things and new features coming out. And it's not just new features. It's also improving the ability to navigate through the app. I think that what one may suggest that the PayPal app is in need of a refresh, it's a little tired right now. And certainly, we look at competitor offerings out there that have less friction, make it easier to navigate. But the things that are most relevant to you, most prominent on the landing page. And so we really have taken a fresh approach to make those user experiences great. So again, though I'd emphasize that this is not as if we've got a finite list of the things that we're going to do and then we're complete and we just move on. This is going to be a constant iteration where we want the app to get better and better. And with every new product that we roll out, we do A/B testing to learn. What is the best functionality? Where should this be placed? How do people use this? What is the halo effect of this on other products? And so all of these things require iteration on our part, and so this will be an ongoing process over the next 5 years.

A similar question on the PayPal Commerce Platform for merchants in terms of what are the biggest investments you'll be making? And is there anything that might be seen as transformational from the merchant side?

Well, the real, I think, appeal -- well let me step back actually before I go there. But the acquisition of Honey and what that allows us to do to get into commerce, has some obvious synergistic benefits. Having PayPal as a payment option on there, even Buy Now, Pay Later, if you think about that product in that experience. But it's really what we can do to leverage the data, to your point, to help merchants. And merchants today have a number of alternatives with how they spend their marketing dollars. And if you think about getting to the end of the quarter, and look, you want to increase your level of revenue, some merchants may do banner advertising or something like that. And the ROI on that is relatively low. What we're leaning into, what we're really trying to promote, is to have better fidelity or better ROI on those marketing dollars that a merchant can spend. Because what we're doing is basically collecting data of what those consumer preferences are, at what price point do they want to buy something at a certain shoe size or whatever it is. And if we have basically a log of hundreds of thousands of preferences that customers have selected, we can alert merchants and say, look, if you lower the price of shoes by $5 or whatever in this color, we know that we've got this segment of customers that are willing to buy that. And so what it does is provide an alternative to merchants from something different from traditional advertising or marketing that seemingly has a much higher ROI on that spend. And that's a fundamental shift in the way that merchants are spending their marketing dollars today. And so it's good for merchants. It's also obviously great for consumers because they're getting offers that are tailored to their own preferences that they've listed. And of course, we benefit as well by driving that connection between the two. And so this is a big investment. It's a multiyear path, but one we're excited about. And look, I think the other thing around this is what we can do with reward points, Honey Gold, and how that interacts with that experience that I just described. And so we think it's a pretty promising opportunity to get into this commerce area that, heretofore, we've really not made any headwind.

I'd like to just close, John, with a question on transaction authorization rates. You indicated that you've raised transaction auth rates by 400 basis points since 2018. What investments are you making to increase transaction authorization rates going forward? And how high can they actually go?

Well, there's a theoretical limit to it at 100%. But that would mean that we're authorizing even the bad actors, the potential fraudulent transactions. And so what we're really after is to get to 100% of good users. And there's a lot that we can do that we've made significant progress here. And to be clear, like this is -- this is one of those areas that is good for our customers, it's good for PayPal, but it's also good for the issuers, right? We see that we're helping them get more revenue by helping to authorize these transactions. And this is where our data, I think, really comes to bear by having the amount of data that we do seen, having the visibility into the merchant side and the consumer side. And so there's a lot more room to go here. And there's a lot that we can do, too, just around like using our data, for example, like when we know that the card is going still, it's getting ready to expire. Being able to vault the second card that you have in your wallet or the data that we have around stolen credit cards. And so these are all things that we can do to improve those experiences among those good users. And I -- our goal is to get to 100% of good user authorization. It's probably a pretty challenging goal, but we've made tremendous progress here over the last few years and expect to continue to do it going forward.

John, thanks so much for your time and insights. Greatly appreciate it and look forward to all the innovations to come from PayPal over the next couple of years.

Great. Thank you for the opportunity, David. I enjoyed it.

Thank you.