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Stock Strategist

Checking Out PayPal

It has a head start in an increasingly competitive electronic payment market.

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 PayPal (PYPL) is a company at a crossroads as it splits from eBay (EBAY). The payment industry is rapidly evolving, creating endless opportunities for the firm to capitalize on its growing network but encouraging the proliferation of new competitors. The company has a big head start over its wallet competitors in terms of trust and online acceptance, which should allow it to benefit from the rapid growth of digital payments over the near term.

PayPal lacks control over key software and hardware functions in the smartphone space, a position we see as a double-edge sword. This creates the potential for PayPal to be eventually squeezed out of the physical and mobile point of sale by larger players including Apple (AAPL) and Google (GOOG). An initial foray into the physical realm with Home Depot and Discover fizzled immediately, and the aforementioned competitors--along with newcomers like Stripe--are beginning to make inroads into PayPal's home turf online.

That said, PayPal's primary disadvantage could also work in its favor. Merchants have been searching for an alternative to existing payment schemes, and PayPal could easily fit the bill. In fact, the company's Paydiant division is powering several merchant-run payment platforms, including MCX, a troubled attempt by retailers to develop a low-cost payment alternative. Unlike Google, Amazon (AMZN), and the networks that maintain close ties to issuing banks, an independent PayPal is a natural ally for merchants, and each could benefit from a greater PayPal presence in commerce.

There are also several factors protecting PayPal's position. Its nascent One Touch initiative has already been introduced for both traditional online and smartphone payments, positioning it well against Apple Pay. Merchants must also manage the proliferation of checkout options on their sites--from Visa's (V) Checkout to American Express' (AXP) Express Checkout--and PayPal has a strong incumbent position. PayPal is planning more aggressive customer acquisition efforts as it achieves independence. It  is already adding active users at a 9% annual rate, and we wouldn't be surprised to see this accelerate as PayPal continues to widen its net beyond eBay.

Network and Name Are Competitive Advantages
We award PayPal a narrow moat rating. The company's digital wallet is an established leader in online commerce, and PayPal boasts a network of users and merchants on par with traditional closed-loop payment networks like Discover (DFS) and American Express. We also think the PayPal brand is a valuable intangible asset, as the company is arguably the best-known provider of secure online payments. These two advantages should be sufficient to allow the company to earn excess returns on capital for an extended time frame, much as other players in the payment ecosystem do. However, our confidence in the company's competitive position fades as we look out more than a decade and the line between online commerce--PayPal's historical stronghold--and physical commerce blurs. Increasing use of mobile devices in the virtual environment and at the point of sale has opened the door to new competitors like Apple Pay and Android Pay, and PayPal's continued relevance in this environment is less certain. In our view, PayPal's success therefore depends on the firm becoming a force to be reckoned with at the physical point of sale--a strong possibility but not a certainty at this point. As an online-only firm, PayPal faces a variety of new and established technology firms vying for business on the basis of pricing, customer service, security, and ease of use--attributes that do not lend themselves to sustainable competitive advantages.

PayPal is clearly expanding its network, adding users and merchants quarterly and strengthening its competitive advantage. It should also become more attractive to merchants as an independent firm--eBay, like Amazon, was often seen as a competitor to other online retailers. However, while PayPal dominated the online payment space for much of the past decade, a resurgence in competition has led to other firms gaining a foothold at the intersection of physical and virtual commerce, from newcomers like Stripe and Apple to more established competitors like Visa's CyberSource.

PayPal does have several options for widening its moat over the next few years, and its ambitions are large. Much as the company initially provided an alternative to Visa and MasterCard (MA), it is now positioning itself to become a more merchant-friendly competitor to both existing payment networks and digital wallets. Its Paydiant division, for example, provides white-label wallet services to merchants and is providing credit on the edges of the traditional banking system. PayPal has long offered consumer money transfers, and its acquisitions of Venmo (through Braintree) and Xoom added considerably to its capabilities in this arena. Furthermore, it has the opportunity to occupy a position as a platform-agnostic, network-agnostic payment provider in a changing ecosystem. Overall, we believe the competitive threats and opportunities are balanced.

Digital Lead Threatened, but Financial Health Sound
PayPal is a still a relatively small player in a rapidly evolving payment marketplace, with far fewer users and limited acceptance relative to Visa and MasterCard. Its long-standing lead in the digital wallet space is now threatened as the line between online and physical commerce blurs thanks to the widespread use of mobile devices. Furthermore, the company's increased exposure to massive retailers--and their staggering bargaining power--is likely to pressure pricing, especially relative to the past when the company largely provided the only option to small Internet merchants.

PayPal is in sound financial health. The company is quite profitable, generates significant free cash flow, and is emerging as an independent entity with little debt. We expect the company to direct its cash toward growth and acquisitions over the medium term and do not expect any dividends or buybacks for the foreseeable future. We expect the company to be quite conservative with its roughly $6 billion initial cash balance given the rapid pace of change in its business, using it for customer acquisition and produce development. We would be surprised to see PayPal take on much debt.

Investing in Growth Wise at This Point
We believe the new management team, under former American Express executive Dan Schulman, is well qualified to run a modern financial services firm. We think the company's overall platform-neutral strategy makes sense, and we think it is positioned well to compete in the fast-growing payment space. We like that the company is investing in growth rather than dividends or buybacks at this point--PayPal must stay ahead of competitors in terms of both technology and network expansion if it is to successfully navigate the transition to mobile.

That said, we expect PayPal to be relatively acquisitive. The company spent roughly $2 billion on the purchases of Paydiant, Braintree, and Xoom over the past several years as it continued to diversify its offerings and keep up with the latest technological innovations. We believe the company's strategy makes sense, but management's capital-allocation skills may be tested as the ability to craft deals will essentially be mandatory as PayPal's growth continues.

Jim Sinegal has a position in the following securities mentioned above: GOOG. Find out about Morningstar’s editorial policies.