Forget Twitter… Elon Musk Should Have Bought PayPal (PYPL) Instead

Stocks to buy

Last week, Elon Musk announced that he would like X (formerly known as Twitter) to become the center of your financial world.

“If it involves money, it’ll be on our platform,” Musk said in an all-hands call with the social app’s employees. “Money or securities or whatever. So, it’s not just like send $20 to my friend. I’m talking about, like, you won’t need a bank account.”

Perhaps he will succeed. X has roughly 550 million active users and a payment processing system already in place. The firm also has licenses for money transmission and services in nine U.S. states, according to the Nationwide Mortgage Licensing System. Most tellingly, Musk has even rebranded Twitter to the “X.com” name — the trademark he tried converting PayPal (NASDAQ:PYPL) into before getting ousted as CEO in 2000. He has the rare combination of money, willpower, and a lack of decorum to make things happen.

But these efforts to turn X into a financial hub are doing things the hard way. Because instead of buying Twitter…

…Elon Musk should have repurchased PayPal instead.

PayPal: The Diamond in the Rough

It’s been a tough several years for PayPal, an electronic payments company that’s seen its share prices drop 85% since 2021. Over the past two years, analysts have cut their forward earnings estimates for PayPal from $7.20 per share to $4.95, sending PYPL stock into freefall.

The problem stems from a surge in expenses, driven by rising volumes of low-margin business and an uptick in credit losses. Credit card defaults are now growing at the fastest pace since the 2008 financial crisis. The growth of peer-to-peer transactions has also increased fraud rates.

However, these downbeat figures have turned an otherwise growing company into a deep value play. Markets now value PayPal at only $56 billion — not much more than the $44 billion Elon Musk paid for Twitter.

At current prices, PayPal sits at just 11x free cash flow or 9.2x forward earnings — levels more typically seen at zero-growth industrial companies or struggling banks. Prices are so low that the company’s $5-billion-per-year of free cash flow could theoretically pay for the entire company in just over seven years. (Twitter was bleeding $379 million annually when Musk took over).

Meanwhile, PayPal’s business continues to march ahead. Analysts expect PayPal’s sales to increase between 7%-9% annually through at least 2025 and for earnings per share to return to double-digit growth after this year.

That’s because PayPal’s customer acquisition strategy largely relies on network effects, which costs virtually nothing to maintain. The company spends just over 10% on its entire sales and marketing team. By comparison, Capital One (NYSE:COF) pours a stunning 21% of its operating budget into marketing expenses. It’s far cheaper to install a yellow “PayPal Checkout” button on a website than to get real-life customers to sign up for a “What’s In Your Wallet” credit card.

That’s turned PayPal into a profit-spinning machine despite lower margins. The company’s return on capital exceeds 33%, and analysts expect free cash flows to rise double-digits through 2026.

The Actual Everything App

Musk, however, might be even more interested in PayPal for its ownership of Venmo, a peer-to-peer payments app that PayPal acquired in 2013 through its purchase of Braintree. The service now counts at least 90 million accounts in the U.S., or 1 for every 3.5 people. Payment volumes are also surging. In Q2 2022, PayPal noted that Venmo saw a 250% transaction growth.

That’s because Venmo enjoys even more robust network effects than PayPal. Venmo’s peer-to-peer payment network only works if both parties have the same app, which means winners in the industry tend to keep growing while laggards are left behind. It’s much like the Betamax vs. VHS wars of the 1980s. Once a standard is adopted, it’s hard to switch to anything else.

At the moment, Venmo appears to be on the VHS side of that equation. The company has been using Cash App’s playbook to acquire customers, offering cash prizes to sign up young users. The subsidiary has also been working with vendors and online merchants to serve Venmo as a payment option and broadening its reach beyond a peer-to-peer model.

Most importantly (especially to Musk), Venmo and PayPal are expanding their credit and debit card offerings. This month, the firm announced that iPhone users will now be able to add these cards to their Apple Wallet, essentially cutting out the commercial bank middle-man. It’s effectively becoming the center of users’ financial worlds — or what Musk dreams X might someday become.

The Need for Patience

Of course, an investment in PayPal comes with risks. My MarketMasterAI stock-picking system awards PayPal a C grade for its negative momentum and analyst downgrades. History tells us that falling stocks usually keep going down before a recovery. According to the quantitative system, PayPal’s expected stock return is only 2.3% over the next six months.

PayPal is also facing growing competition… not least from Musk’s X app. In 2019, the payments sector saw several blockbuster acquisitions consolidating the market. Fidelity National Information Services (NYSE:FIS) acquired Worldpay in a $43 billion deal, Fiserv (NYSE:FI) scooped up First Data for $22 billion, and Global Payments (NYSE:GPN) bought TSYS for $21.5 billion. These efforts were aimed directly at competing against PayPal.

Finally, PayPal’s move into debit and credit cards comes with banking-related risks. In 2022, the company booked $402 million in credit losses, representing around 6.8% of all outstanding loans. Much of this increase came from buy-now-pay-later products, which typically have high default rates. As PayPal continues to add banking-related services to its product lineup, investors will need to price the firm more like a bank, which typically trades at significant discounts.

Lessons From Apple Pay

Nevertheless, the experience of Apple Pay tells us why it would have been easier for Elon Musk to buy PayPal instead of converting Twitter into a financial hub.

In 2014, Apple (NASDAQ:AAPL) CEO Tim Cook proclaimed that his firm would “forever change the way all of us buy things.” His firm launched Apple Pay that October and aggressively pursued merchants to adopt the system. By 2019, even the New York transit system allowed Apple Pay on subways and buses.

However, even Apple couldn’t get its customers to switch.

According to a study by Capital One, only 9.3% of iPhone owners used Apple Pay for in-store purchases in 2022. That’s despite Apple Pay being accepted at 90% of U.S. retail stores. Even high-yield Apple savings accounts — which currently yield 4.15% APRs— have struggled to gain customers. The $10 billion deposited into Apple Card’s savings accounts is just $6.85 per active iPhone user.

That’s because banking habits are hard to change. According to Bankrate, the average U.S. consumer holds onto the same checking account for 17.75 years. Younger millennials under 32 have kept their checking accounts for over nine years. There’s a reason why local banks and credit unions give handsome sign-up bonuses for new accounts. Nine years of Apple Pay has only given the Cupertino-based firm a 12.62% share of the online payments market.

Then there’s PayPal, a company that controls 56.15% of online payments. Its shares are trading at multi-year lows. It’s highly profitable. It generates plenty of cash. And it’s available on public markets for you and me to buy. Better act now before Musk decides to make another purchase.

 As of this writing, Tom Yeung did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.

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