rewrite this title PayPal vs. Block: Value or Value Traps? – Nanalyze

PayPal stock is trading at a relative bargain. But the growth story is hard to read through the fog of the post-pandemic economy and opaque reporting structure. That’s what we concluded just over three years ago and that mostly holds true today. If you want to invest in a company with strong cash flows and moderate growth, PayPal (PYPL) is a suitable option at a reasonable simple valuation ratio (SVR) of just two. That’s less than it was three years ago, and their market cap has dropped from $85 billion to $67 billion. Looks like we haven’t missed much. Revenue growth continues to decelerate which means PayPal more than deserves the low valuation it continues to enjoy.

What has changed is, they’re now providing more color on the type of business you’re investing in. The total amount of volume flowing through their platform – total payment volume or TPV – is now divided into three segments.

How PayPal Makes Money

While most retail investors are probably familiar with using PayPal for online transactions, or Venmo for transferring cash around, PayPal does a lot more behind the scenes.

Branded checkout is the ability to pay with Venmo or PayPal when conducting online transactions

P2P & other consumer includes person-to-person payments using Venmo or PayPal, but excludes branded online transactions

Payment service provider represents unbranded card processing across the Braintree and PayPal platforms, as well as other merchant solutions (e.g., payouts, invoicing, point-of-sale solutions, etc.)

Clear as mud, right? And because Venmo crosses multiple segments, they’ve broken that out into a separate metric. The Venmo app represents 18% of total payment volume across their entire platform.

Note that TPV provides no indication of revenues and profitability for each of these segments. And when you delve further into the PayPal investor deck, things become even more convoluted. More metrics make things more difficult to analyze. What does it all mean?

In the universe of fintech companies that offer platforms measured in volume, it’s a race to the bottom. All it takes to sway a customer from one platform to another is some temporary salacious offer that costs little more than marketing dollars. For merchants, price will always be a key factor in determining which vendor to choose. And indeed, we see consistent downward pressure on gross margins for PayPal over time.

While revenues enjoy high single-digit growth, that’s being offset by decreased profitability over time. The same can be observed in another key metric – take rate.

Last quarter, PayPal saw $443 billion of TPV flow through their platform. Of that, they captured 1.87% or $8.3 billion as revenues. That’s called a “take rate.” Of those revenues, $3.5 billion represented gross profit. That’s how we arrive at the 42% gross margin. Everything is related and there are lots of moving parts. Over the years, PayPal’s take rate has been on a consistent and predictable decline – from around 3% in 2015 to under 2% today.

That means PayPal needs to increase total payment volume above and beyond the take rate decline to increase profitability, and even higher if they want to get ahead of the declining gross margin headwinds. All the while, formidable competitors like Stripe (private) and Block (XYZ) are eagerly nipping at PayPal’s heels.

Block’s Funky Revenues

Forget about a nicely organized selection of earnings decks and a freshly updated investor presentation. Block provides none of that. Even a metric as simple as “revenues” is convoluted. That’s because Block sells bitcoin to their Cash App customers and then counts that as revenues. The result is that while bitcoin accounted for nearly 40% of total revenues last quarter, it only contributed 4% to total gross profits.

In other words, all this bitcoin number does is obfuscate revenue growth, and it’s also quite volatile (as seen above), because that’s how degens operate. When bitcoin is at all-time highs, you buy it, then when it hits a new low, you sell it. Even Block realizes this because they ignore revenues altogether in their earnings decks. “Gross profit” is the key metric for which they judge their business. Even guidance is given in gross profit.

So, it’s best to leave bitcoin out of any Block analysis. Yes, even the $932 million in bitcoin Block irresponsibly holds on their balance sheet as an “investment.” Instead, we focus on the two segments driving 96% of gross profits – Square (40%) and Cash App (60%).

PayPal’s Venmo and Block’s Cash App compete directly for customers. It’s almost a zero-sum game with PayPal having an advantage with stronger cash flows to fuel marketing. Block is reliant on Cash App for 60% of their gross profit, while PayPal’s Venmo makes up just 18% of TPV across their platform. Then you have Block’s “Square” and PayPal’s “Merchant Services” where competition isn’t so direct. Square is said to be stronger for in-person transactions and SMB-focused tools, while PayPal excels in e-commerce and international payments. When examining these very complicated businesses, we always look for simple metrics to monitor – like gross profit.

Homing In On Gross Profit

Monitoring these companies is difficult. You can’t use revenue growth because it’s not an accurate picture of progress. Cash flows become too volatile because of timing issues. Profitability becomes obscured by any number of measures. If one company spends more on marketing, they can increase revenues, but now they’re less profitable. That sort of thing. Perhaps gross profit is the most telling metric for both companies over time. We’ve charted that out below.

To compete on cost, you need to be the leader. To become the leader, you must spend lots of sales & marketing dollars stealing market share from your competitors. The company with the most capital to deploy should eventually come out ahead. And generating your own capital is strongly preferred to taking on debt or diluting existing shareholders by selling more shares. PayPal’s strong operating cash flows point to them having the edge over Block.

While PayPal is seeing gross margins drift lower over time, Block has been consistently moving their gross margin in the right direction – upwards. Both companies – PayPal and Block are gravitating to gross margins around 40% which implies this might be the norm. But which business is better?

Block Stock or PayPal Stock?

We wouldn’t invest in either because we’re going with Adyen for reasons we detailed in numerous pieces over the years. But let’s say we had to choose between PayPal and Block. Valuation is out the window for obvious reasons. We can’t use revenue metrics because it’s apples to oranges while the winner will most likely be the company with the least profitability because that means they’re spending all that gross profit on capturing customers through sales & marketing efforts.

At the highest level, we have no interest in the consumer apps on offer from either of these firms. What’s the barrier to entry here for any consumer banking app to offer peer-to-peer transfers? Sure, there’s a bit of a network effect here, but the target demographic is only one Taylor Swift commercial away from mass migration. Block has the most dependence on their consumer app as it represents 60% of their total gross profits. PayPal doesn’t disclose this number for Venmo, but they have stronger cash flows that can fuel a massive marketing push. With Venmo being just 18% of total payment volume, it’s clearly a smaller part of their business. PayPal comes out ahead for that reason alone, but are they really focused on growth at all costs?

A leader in this space ought to be spending every bit of spare cash on further eviscerating the competition until they dwindle into obscurity. All these platforms enjoy a network effect – the larger they become, the less appealing it becomes to use a competing platform. So what does PayPal plan to do with all that cash they’re generating – $30 billion in positive operating cash flows over the past five years? They’re spending half of it on buying back shares with a new $15 billion repurchase program announced earlier this year. That’s not what a growth company should be doing with their spoils.

Conclusion

Both Block and PayPal are listed in our tech stock catalog as “avoids,” so why are we revisiting them? Because every few years you ought to check in with those names you’ve dismissed to see if the thesis has changed. These are larger companies – PayPal ($68 billion) and Block ($48 billion). They also compete with a payments company we’re holding – Adyen (ADYEN AS) – to a certain extent, though Adyen’s platform sits further back in the payments stack, and focuses more on larger enterprises vs SMBs.

Investing in either of these companies means you’ll need to start understanding and monitoring whatever key metrics are offered up. PayPal provides a rich set of proprietary metrics while Block can’t be asked to provide much. Each provides a consumer app that’s extending well beyond peer-to-peer money swapping and into “buy now pay later” (BNPL), bitcoin, and even more borrowing. Getting fickle consumers to switch between these two is a matter of marketing dollars. Harvesting the rewards? A race to the bottom. If we had to choose one, it would be PayPal, but we’d rather stick with Adyen which we’ll be revisiting later this year.