Vista Equity Partners and Model N: An LBO Analysis

 (Disclaimer: Excel file attached below the post) 

In case it isn't painfully obvious by now, I am fascinated by M&A and LBO transactions, and always have an eye out for a transaction that I might find intriguing; one such transaction was announced roughly two weeks ago when Model N (NYSE: MODN), a leader in revenue optimization and compliance for pharmaceutical, med-tech, and high-tech innovators, announced that it has entered into a definitive agreement to be acquired by Vista Equity Partners, a leading global investment firm focused primarily on enterprise software, data, and technology enabled businesses, for $30.00 per share (~$1.25B transactional value) in an all cash deal. I wanted to analyze the deal and see what the future holds for Model N, what changes, if any, Vista can make to boost the value of the company, and finally what the returns might look like at exit. I will succinctly talk about Model N, its strategy and future, and then delve right into the transaction. 

Model N

Business

Model N is an industry leading provider of revenue management services within the life sciences and high tech companies; company's products and services allow companies such as Johnson & Johnson, AstraZeneca, Stryker, Seagate Technology and Broadcom in driving mission critical processes such as pricing, quoting, contracting, rebates and incentives. Model N's deep industry experience and its leading cloud-based technology have led to the firm's monumental success over the years. Historically speaking, companies, in this space, have relied on siloed and disjointed operations through manual processes, spreadsheets, and legacy systems to manage their revenue processes. Due to the isolation, these legacy operations often led to missed revenue opportunities, were labor intensive so led to higher costs, as well as being error prone and inflexible, rendering them ineffective in the current environment and most definitely obsolete for the future. 

Model N expertise and cloud-based revenue management solutions, couple with the company's long operational history within this space, has enabled the company to develop software that is uniquely designed and architected to meet the business and strategic needs of these industries; such as managed care and government pricing for life sciences companies and channel incentives management for high tech companies; Model N Revenue Cloud transforms the revenue lifecycle into a strategic, end-to-end process aligned across the enterprise.   

Products

Model N serves as one of the leading revenue management platforms for life sciences and high-tech industries. I think in order to understand what its future prospects look like, we need to first understand its offerings and services that have led to its enviable success.

Revenue Cloud for Life Sciences

Model N's suite of services and applications within the life sciences industry provide companies with end-to-end control and visibility across the company as well as assisting companies with corporate tasks such as customer relations management (CRM) and enterprise resource planning (ERP). The company provides following services within the life-sciences industry.

• Global Pricing Management: This service minimizes price erosion of products in international markets due to competitive pressures and/or government mandate through the product's lifecycle. Global Pricing Management allows companies to use Model N's services and platform to stay abreast of all the related current information that enables them to reach their metrics and margins.
• Global Tender Management: This service optimizes the bidding process and organizes the post-award tracking to efficiently manage the tendering lifecycle through automation.
• Provider Management: Manufacturers can utilize this product to manage complex institutional contracts with Providers. This particular service allows manufacturers to set up contracts using structured and organized pricing and price alerts for each product, allows price look up, and resolution and monitoring of end-to-end workflows. 
• Payer Management: Minimized revenue leakage and noncompliance of complicated contracts with Payers. Payer management is an end-to-end industry leading management solution that helps eliminate revenue leakage in payer rebating processes.
• Government Pricing: Supports Federal government mandated calculations and reporting requirements for average and minimum prices achieved by manufacturers across their portfolio of products.
• Medicaid: Improves compliance and regulatory requirements and ensures payment of rebate claims on a timely basis and at correct rates for government Medicaid programs. 
• Validata: Enables manufacturers to validate, summarize and analyze prescription level information in connection with processing of various forms of rebates to ensure accurate payments are made and duplicated reimbursements are avoided. 
• Intelligence Cloud: Integrated business intelligence application to provide KPIs and trend analytics on all aspect of pricing, contracting, and discounting data across a host of solutions through easy configuration and centralized dashboard. 
• Advanced Membership Management: Helps manufacturers manage their customers' membership with specific Group Purchasing Organizations (GPOs). This service also enables manufacturers in avoiding revenue leakage through validation eligibility for contracted pricing and ensuring compliance with specific rebate policies. 

Revenue Cloud for High Tech

Model N's platform and services allow companies in the high-tech industry to adopt a strategic approach that enables the modernization of sales processes and therefore effective revenue management. Company provides following services to companies in high-tech industry.

• Deal Management: Enables companies with high deal conversion and pricing consistency with pricing, quotes, and contracts natively supporting the high-tech space. 
• data Intelligence: Accords companies the ability to analyze historical deal data, and measure the impact of different pricing strategies and the impact on current deals. 
• Channel Management: Provides manufacturers a more transparent view of their inventory as well as the ability to perform actions such as price protection, stock rotation and matching available inventory quotes. 
• Market Development Fund Management: Allows companies to streamline their marketing development funds programs and reduce revenue leakage by increasing partner participation through a self-service portal. 
• Rebates Management: Centralizes control of rebate programs to reduce upfront discounts and enables effective management of all incentives. 
• Payment Management: Allows companies to pay, audit, and manage incentive payments globally while reducing costs to ensure accuracy and minimize revenue and opportunity leakage.
• NGage: An in-app guidance application that helps customers drive and measure channel/user adoption, change management and process excellence. 

With an understanding of Model N's background, the industry it performs in, its offerings and services, the next thing that I would like to discuss are the company's strengths and its unique position in the industry that allows it to perform all of the above stated services with the utmost efficiency. 

Strengths

• Comprehensive approach to revenue management: Model N's enterprise solutions provide a comprehensive look at the processes and provides end-to-end revenue management throughout the lifecycle of all products. This comprehensive approach makes it easy for Model N's customers to reverse the damage caused by siloed and disjointed operations and processes.
• Deep domain knowledge: Model N is considered an expert in the life sciences and high tech industries and, therefore, is uniquely positioned to provide solutions and services that are specifically catered for companies within this space. 
• Strong customer base: The company, over the years, has established a reputation for delivering revenue management solutions to leading companies and have thus fostered long lasting and pivotal relationships; these relationships and the resulting recurring revenue allows the company to meet its internally set metrics and goals.
• Flexible deployment model: Model N possesses the ability to disperse its services and applications in multiple forms which gives the company a competitive advantage as well as the flexibility that is required by its customers; this flexibility enables Model N to deploy its solutions as SaaS applications, as fully managed and outsourced business services, or in a hybrid model mixing both SaaS and business services.
• Talented team focused on customer success: Model N employs experts and professionals that have been in the industry for a while now, and as a result, conduct a pivotal role in the company's success from developing services and applications to establishing business relationships as well as purveying its solutions to companies across the life sciences and high tech industries. 

LBO Transaction

Setting the Stage

I think that I am in a comfortable position where I can safely analyze the company's future, the transaction and the returns. To start us off with the analysis, here are some preliminary assumptions and back of the envelop numbers that I think are tantamount to understanding this post. 

As I mentioned at the start of the post, Vista offered $30 per share for all of Model N's outstanding shares, and given Model N's diluted shares outstanding of 40.8M, we get an offer value (equity value) of $1.225B, which, given Model N's last reported net debt of -$21M, yields an enterprise value of $1.204B. Additionally, Model N reported on its latest 8K an adjusted EBITDA of $42.9M, giving me an EBITDA multiple of 28.1x. The offered premium shown in my analysis is slightly different than the reported premium of 23% and that is because I am only comparing to the price from a month ago whereas the reported premium was based on the weighted average of Model N's share price for the last month. Some other assumptions that I made were about the minimum cash and the sources and uses of the proposed transaction; I am assuming that Vista will keep around $100M cash balance at minimum to support the working capital and other investment needs of the company going forward; I am assuming that the acquirer will opt to utilize the remaining cash balance of $201M to support the transaction as well as paying $1.3B of their own money. Since this a cash transaction, I am assuming that they will not use debt for this transaction, but I have left the functionality in the model because I will, towards the end, compare returns without debt to a scenario where they do take on debt. Let's now look at the historical income statement and understand the breakdown of its revenues and costs as well as its operating expenses and EBITDA.  

Going back three years, Model N reported total revenues of $193M (FY '21), $219M (FY '22), and $249M (FY '23); company reported a revenue growth of 13% and 13.8% for the last two reported years. As is evident from the image above, subscription revenue constitutes for most of the company's total revenues with the company having reported subscription revenues as a percentage of total revenues of 74%, 73%, and 73% for FY '21, '22, and '23, respectively; professional services revenues constituted the rest of the revenues for the last three years, professional services revenues have been around the 27% mark of total revenues for the observed period. Furthermore, Model N has reported total costs of revenues of $97M (44% of total revenue) and $108M (43% of total revenue) for FY '22 and '23, respectively; company also reported operating expenses of $135M (61.6% of total revenue) and $145M (58% of total revenue) for FY '22 and '23, respectively. Company has additionally reported gross margins of 55% (FY '21), 55.7% (FY '22) and 56.6% (FY '23) as well as reporting net profit margins of -15.4% (FY '21), -13% (FY '22) and -13.6% (FY '23). Lastly, having rummaged through its 8K, the company reported adjusted EBITDA of $32M (14.6% margins) and $49M (17.2% margins) for FY '22 and '23, respectively. I will not being going over the company's balance sheet as I don't believe that it is relevant to our discussion or even accretive to the analysis. Let's now look at my assumptions about the company's future and see how they might impact the numbers for the next five years. 

Assumptions (Base Case)

• Revenue Growth: I expect revenues to increase at a modest rate for the next five years. I believe that going forward subscription revenues will grow from 13.5% in FY '23 to 20% by the end of FY '28; I also believe that professional services revenues will grow from 14.7% in FY '23 to 18% in FY '28; I expect total revenues to grow from $249M (14% YOY growth) in FY '23 to $553M (19.5% YOY growth) by the end of FY '28. There are multiple factors that I believe will lead to this growth in revenues: I expect Model N's brand name, coupled with Vista's experience within the tech and enterprise software space, to play a pivotal role going forward; I also believe that Model N's deep knowledge of the industry will help the company in keeping its competitive advantage and keep improving its margins; I expect that Model N's customer base will not only persist, but will grow as the company spends more on R&D and sales and marketing for the next five years; some additional reasons for my expected revenue growth are its people, flexible method of deployment, increased enhancement of its services and platforms, and its comprehensive approach for revenue management. 
• Costs of Revenue: This will be one of the many factors that the PE firm will be focused on in terms of improving margins along with inflating EBITDA and expanding the multiple. As Vista tries to grow the company in the coming five years, I expect that the firm will be able to reduce its costs concurrently with its revenue growth. I believe that, given their domain knowledge and experience with operating companies within this space, Vista will be able to reduce costs of subscription revenues from 35% as a percentage of subscription revenues to 30% by the end of the holding period as well as reducing costs of professional services revenues as a percentage of professional services revenues from 66% in FY '23 to 55% by the end of FY '28.   
• Operating Expenses: Model N's operating expenses consist of research and development costs, sales and marketing, and general and administrative; as the company grows and gets more efficient in terms of generating more revenues from its current clients as well as onboarding more clients and developing professional relationships at a minimal cost, its operating expenses should reduce throughout the holding period as a percentage of total revenue. I expect the company to keep investing in its R&D in order to sustain and support the growth in revenue, furthermore, I believe that as the company tries to grow its revenues, it will need to invest in R&D to enhance its current offerings and services as well as developing and using new technologies to entice more and more companies to use its platform. As the company grows and gains a firmer foothold within the industry, I believe that sales and marketing costs should reduce as a percentage of revenue; I expect sales and marketing to reduce from 21.7% in FY '23 to 20% by the end of the FY '28. Lastly, I believe that Vista, in conjunction with Model N's management, will be able to reduce its headcount and other administrative charges from 17.2% to 15% as a percentage of total revenue. Overall, I expect total expenses as a percentage of total revenues to go downhill from being 58.3% in FY '23 to 54% by FY '28.
• Asset Utilization: Better asset utilization is one of the levers of a private equity transaction, and given that we are analyzing this transaction, I am assuming that Vista has recognized better ways to utilize Model N's assets in order to reduce the associated costs and increase the incremental revenues. 
• Multiple Expansion: Multiple expansion is by far one the difficult paths to inflate returns for an investment firm; it is a gargantuan task because not only does it depend on how the company performs, but also on the macro trends. Multiple expansion relies on tentative issues such as the market conditions, interest rates, future valuations, buyers' sentiments, and the industry outlook, issues that no one can honestly predict. With that being said, there are less than ideal ways to inflate multiples by the time of the exit and they include but are not limited to geographic expansion, more long-term contracts with companies, product diversifications, and a better outlook for the company and the industry. Additionally, given that Vista dabbles in technology and enterprise software companies, they might be able to bolt-on another company onto Model N down the road in order to attain steroidal returns.  
• EBITDA Expansion: Unlike multiple expansion, EBITDA expansion is an attainable goal, and given my assumptions surrounding revenue growth and reduction in costs, I expect Model N's adjusted EBITDA to grow from $42.8M (EBITDA margins of 17.2%) in FY '23 to $111.03M (EBITDA margins of 20%) by the end of FY '28.
• Deleveraging: I have not assumed any debt for this transaction, but I will play out a scenario by the end of the post where I do look at the possibility of assuming debt for this purchase and how Model N and Vista could go about paying it off early in order to get the desired fortuitous returns; as the model will show, the company barely generates enough cash flows to support interest payments let alone the associated mandatory amortization and any discretionary payments for term loans. 
• Vista's Portfolio: Vista's is an investment firm that is known worldwide for its expertise in enterprise software, data, and technology businesses, and I believe that the firm will be able to, if not exceed, my revenue estimates and cost reductions and should very easily be able to realize their expected returns. I further believe- given my projections- that Vista will more than likely add another company onto Model N in order to not only inflate revenues but also to increase their returns through synergies, pricing power, bargaining power, lower CAC, and an improved cost structure. 

With all of our assumptions out of the way, here is a look at the forward looking income statement and gross, net profit and EBITDA margins. 

As you can see, I expect Model N's total revenues to increase from $249M in FY '23 to $553M by the end of FY '28; I expect total costs of revenues to reduce from being 43% of total revenues in FY '23 to 36.7% by the end of the holding period. As is also evident from the screenshot above, I expect total operating expenses to reduce from being 58% of total revenue to around 54% by the end of FY'28. I expect the company to report a positive EBIT by the end of the first year and the reason is two-fold: first and foremost, I am assuming a growth in revenues and reduction in costs so more funds are flowing towards the operating income, and secondly, I am assuming an all cash payment and no debt involved which means that there is no interest expense. In terms of margins, I expect the company's gross margins to improve from 56.6% in FY '23 to 63.3% by FY '28; furthermore, as stated in the assumptions, I expect EBITDA margins to improve from 17.5% in FY '23 to 20% by FY '28. Here is what I think the balance sheet line items could like in the future:

I think the balance sheet speaks for itself, and with income statement and balance sheet projections in place, let's look at the going forward cash flow statement:

As you can see, Model N (in my base case) is generating a healthy amount of free cash flows with projections increasing from $44M in FY '24 to $103M by the end of FY '28; as stated before, please bear in mind that these excess cash flows are majorly due to the fact that we are not assuming any debt in this transaction, this of course also makes it relatively easier for Vista to pay itself a dividend down the lane to spice up their returns even more. Now, for the sake of this particular conversation, if I assume that Vista ends up raising ~$1.4B in debt, here is how drastically different the cash flow statement might look like:

As you can clearly see, the company does not have enough cash remaining after making the interest payments and the mandatory amortization, as a matter of fact, the model predicts that they might need to draw down on their revolver to break even. There are of course a thousand different ways this could go, but I just wanted to highlight the company's ability, or lack thereof, to meet its debt obligations. With income statement, balance sheet and cash flow statement explained, let's now move on to the crux of the analysis: the returns.

Returns:

I think that I am in a decent place to now discuss the possible returns for Vista, I think it is important to notate here again that these returns are based on the fact that there is no debt raised and that Vista is paying for the entire transaction with their available powder, with that side note, lets look at the possible enterprise and equity values at different multiples. 

As you can see, assuming the same exit multiple and no other dilution from preferred, management or subordinated equity providers, we get an enterprise value of $3.1B, and given the accumulated balance of cash of $449M, we get an equity value of $3.56B. Of course, if Vista is somehow able to expand their multiple and get a higher multiple at the time of exit, say 30x, the enterprise value would be $3.3B, that would give us an equity value of $3.78B. Let's now look at IRR and MOIC at different multiples. 

Assuming that Vista pays around $1.5B (including fees and Model N's cash balance) and exits at the same multiple that it entered at- 28x- the firm could expect (in my base case) a money on invest capital (MOIC) of 2.7x and an internal rate of return (IRR) of 22%; you might be tempted to ask, "Is that good? Bad? In line with their expectations?" Those are all questions that people that worked on the transaction could answer in a far more intricate manner than I can- all I can say is that given the environment we are in, those returns don't seem too bad to me. Again, this was assuming that Vista pays in cash and raises no debt so the returns could be low due to multiple reasons: firstly, Vista is putting in a lot at the beginning which is why their returns are in low twenties; secondly, I am assuming the same exit multiple, but the returns could be higher if they are able to expand the multiple; and lastly, they might be able to grow the revenues, reduce costs, and expand EBITDA in a far more fashioned and nuanced way than I am anticipating. The lower section of the screenshot highlights the maximum amount Vista can offer given their various internal rates of return. For instance, if we assume that the company will exit at 28x and the equity value of $3.56B, then assuming that their minimum hurdle rate is 25%, they can only afford to offer $1.06B as opposed to $1.23B.  

One last thing that I would like to look at are the returns if they do decide to take on debt; lets assume that Vista chooses to only use $505M of its own cash balance and raises around $857M in debt, here is how the returns might change. 

As you can see, if Vista puts in less of its own money and raises debt, then assuming the same multiple of 28x, we get a MOIC of 5.2x and an IRR of 39%, considerably higher than the returns if no debt was raised. Again, assuming debt, given a minimum hurdle rate of 25%, Vista can afford to offer $1.56 as opposed to $1.23B. 

Conclusion

This is of course an academic exercise aimed primarily at quenching my own curiosity than validating or reaffirming the transaction, with that being said, I think this could prove to be a lucrative deal- how lucrative? Only time will tell. I think I have gone on for far too long, and so I will end it on the note that the value of anything is in the eye's of the buyer.  

Links:

I recommend that you download and open the below attached file in Excel rather than opening it online in Google Sheets.

Model N- LBO Analysis 

  

PayPal (PYPL)- A Deep, Deep Dive

(Disclaimer: Excel file attached below the post) 

I recently came across an article on Yahoo about PayPal and whether or not it is a good time to buy its shares or to sell them, and being that I am an avid user of Xoom and Venmo, I dared to peek inside and it led me into a rabbit hole that inspired and urged me to write this post. My intentions were to understand the company in and out and so instead of valuing the company using conventional methodologies, I decided to analyze and project its financial statements for the next ten years, assess its business model, go over its metrics and ratios, estimate its EPS (both basic and diluted), and to finally top my assessment off with our good old friend, DCF. This will be a fairly long post and so if you are solely interested in the Excel file, it is attached below, and for those kindred spirits that live for these kinds of dissections and have a few minutes, lets jump into our analysis. I would like to start the post off with a snapshot of PYPL's performance over the last few years and compare it to some its close competitors and the broader market indices such as the Nasdaq and S&P. 

As you can see, pre-pandemic, PayPal was performing pretty much on par with its competitors and above S&P and the Nasdaq, and as the pandemic hit and the world came to an abrupt stop, the stock skyrocketed- which given its business model- is not at all that riveting or jaw-dropping. PayPal is just one of the many equities that had an oneiric couple of years due to the shutdowns caused by COVID-19, but what does stand out is its fall from grace; looking at the chart, I can see why investors are being pummeled with news about the stock trading at its historic low. 

PayPal: The Business

PayPal's 2023 10K

PayPal's payment solutions enable its customers, both consumers and merchants alike, to connect, transact, and send and receive payments- online or in-person. The company offers proprietary solutions that are accepted by merchants that enable the completion of payments on its platform. PayPal is truly a company with global presence that has two-sided network at scale that connects merchants and consumers with 426 million active accounts (consisting of 391 million consumer active accounts and 35 million merchant active accounts) across approximately 200 markets as of the end of 2023. PayPal offers customers the ability to use their PayPal and Venmo accounts to make and receive payments for goods and services as well as the ability to transfer and withdraw funds. For consumers, the platform allows customers to exchange funds with merchants using a variety of funding sources, i.e., PayPal or Venmo account balance, PayPal and Venmo branded credit cards, a credit card, a debit card, certain cryptocurrencies, and PayPal's own installment products. As for the merchants, PayPal's platform allows small and mid-sized businesses the capabilities for end-to-end payment solutions that provide authorization and settlement as well as instant access to funds and payout. 

PayPal earns revenues by charging a fee for completing transactions; the company also generates revenue from consumers for currency conversion, for instant transfers from their [consumers'] PayPal or Venmo account to their traditional accounts and to facilitate the purchase or sale of crypto-currencies. PayPal also earns revenue for providing other value added services which comprise revenue earned through partnerships, interest and fees from its merchant and consumer credit products, interest earned on certain assets underlying consumer and customer balances, referral fees, subscription fees, and gateway services.   

Merchants and Consumers 

PayPal's 2023 10K

PayPal, as the image above yells out, drives its revenue from both merchants and consumers, and I think that in order to better assess the company, we need to understand how these two business lines are connected, how they operate, and how they connect to the bigger picture. 

• Merchants
• PayPal partners with merchants and businesses of all sizes, and the company's technology and platform agnostic approach allows for businesses of all sizes to grow, expand, and enhance their relationships with their customers as well processing transactions through multitude of payment methods including PayPal or Venmo account or credit cards, conventional credit or debit cards and accounts, as well as crypto-currencies and other competing platforms. The company offers merchants with fraud prevention, risk management solutions, and helps businesses with reducing their losses through its proprietary protection programs. PayPal's diversified suite of offerings is tailored to meet the needs and wants of all merchants regardless of their size, and the products and the platform allows businesses to not only manage their current customer base but also grow and expand their businesses. The company also offers merchant financing products to small and mid-sized businesses through its merchant financing solutions. Merchant financing solutions consist of PayPal Working Capital and PayPal Business Loan; PayPal Working Capital gives businesses access to capital based on their payments and transactions activity on the platform, and PayPal Business Loans are loans that are made available to small and mid-sized businesses pending the review of the business and its owner. 
• Consumers
• PayPal offers affordable and convenient ways to facilitate the management and movement of money among its consumers. Company allows its users access to a digital wallet that enables customers to send payments to merchants or other users through their digital balance which the company allows the refurbishment of through various funding sources such as bank accounts, PayPal or Venmo account balance, PayPal's consumer credit products, credit cards, and debit cards among others. Additionally, the platform allows for seamless P2P payment solutions for both domestic and international consumers through Xoom and Venmo. Venmo is one of the leading application within the US for P2P payments and transactions; Xoom allows for international transfers in a secure and fast manner. These apps have opened additional pathways for company to acquire new customers by prompting target users to establish active accounts in order to access their funds. The company also offers tools and products for discovery, price tracking and deals and offers for online shopping as well as presenting its consumers with the buy now, pay later products within the confines of certain territories.  

Strengths

PayPal's 2023 10K

PayPal has been in business for a while now and the company has established itself as a brand worthy of envy within the FinTech sector, and in order to further understand its past performance or the potential future, I think we need to look at some of its strengths within the industry.

• Brand
• The company, over the years, has built a brand that is synonymous with information safety, securitized and protected transactions, and convenience. Brands such as Xoom, BrainTree, and Venmo have situated the company across the globe as the platform to use in order to access global populous and enjoy frictionless and secure transactions. 
• Two-sided network
• The company offers a two-sided technology and platform agnostic network which essentially means that the platform connects merchants and consumers through a unique end-to-end product experience that makes the process smooth for consumers as well as offering merchants valuable insights and information as to how consumers interact with PayPal's platform. 
• Merchant and consumer choice
• The company's payment solutions support an open eco-system that allows merchants and consumers to utilize a wide array of options when making and receiving payments, this flexibility is a clear path for the company to reach consumers that use varied methods and applications for payments and transactions. 
• Scale
• PayPal is a true global company with presence in over 200 territories and 426 million accounts (consisting of 391 million consumer and 35 million active merchant accounts) that allow merchants to reach and approach a broader audience than they otherwise would have been able to, and it also provides consumers with endless possibilities in terms of not only buying goods and services but also myriad pathways for payments.  
• Risk and compliance management
• PayPal's risk and compliance management is designed to keep consumers' information safe and secure  and to ensure that the platform processes legitimate transactions around the world while identifying and prohibiting illegal and/or fraudulent transactions.

Show Me the Numbers

With a fairly sound comprehension of the company's business, its past, and its strengths, I think the next logical and intelligible step would be for us to look at the numbers and inspect the company's revenue growth and its costs along with other metrics and margins. 

As you can see, PayPal has put up decent numbers in terms of its net revenues (comprised of transaction and revenues from other value added services), operating income and NI. For the latest fiscal year that ended in Dec '23, the company reported net revenues of $29.7B (comprised of $26.8B in transaction revenues and $2.9B of revenues from other value added services), an 8% YOY growth compared with net revenues of $27.5B for FY '22; company reported total operating expenses of $24.7B (83% of net revenues) for FY '23, yielding an operating income of $5B, yielding operating margins of 16.9%. In terms of the company's operating margins, if we travel back a few years, we see that the company has been putting up consistent margins despite its revolting costs; despite the ups and downs in revenue growth, the costs (both operating and non-operating) have seen little to no variation, something that I will have to take into consideration when thinking about the company's future potential. As evident from the image below, PayPal's EPS (both basic and diluted) have been fairly decent given the nature of the business and the ever increasing saturation of the industry.

Lets now look at the company's historical balance sheet. 

The first thing that stands out is the company's healthy cash balance for all of the observed years; the company reported cash and cash equivalents of $15.8B and $17.3B for FY '22 and '23, respectively. Other line items such as the working capital items, non-current assets, and working liabilities have all seen growth commensurate with revenue growth. Another thing that is also painfully visible is the fact that the company does not hesitate when it comes to raising capital through debt; PayPal reported $6.3B in long-term and current portion and of long-term debt for FY '23, which given its gigantic cash pile, does not seem endangering to the overall health of the company or its liquidity. Additionally, company's past performance can also be measured through the consistent increase in its retained earnings as well as increase in its treasury stock account. As of the end of FY '23, the company does not pay dividends. To further elucidate and understand the company's historic performance, here is a look at its metrics, margins and various financial ratios and I'll let the numbers speak for themselves.

 Financial Statements' Projections and Assumptions

With an understanding of the company's business model, its consumers and customers, its past performance, and a somewhat mediocre comprehension of the industry and the future macro environment, I think I am ready to talk about the company's future and where I think it will end up over the course of the next decade. Before I present my findings and the going-forward statements, I think that it is incumbent upon me to share my assumptions and thoughts so that you can understand follow the numbers.

Assumptions

• Revenues: PayPal's revenues are divided into two categories: Transaction revenues and Revenues from other value added services. I expect (for my base case) total revenues to grow at a CAGR of 6.6% (7.5% for best case and 5.6% for weak case) over the course of the projection period. I have broken down total revenues by categories down below. 
• Transaction revenues: Transaction revenues consist of fees charged to merchants and consumers on a transactional level based on TPV (total payment volume) completed on the platform. The company earns additional revenues from merchants and consumers on currency conversion, cross border transactions, for the facilitation of instant transfer of funds to other users/merchants or simply to transfer funds into their accounts from their PayPal or Venmo accounts. Transaction revenues have historically been above 90% of total revenues  for the past 5 years (with minor fluctuations), and I expect this trend to continue well into the future of the company. I expect transaction revenues to grow at a CAGR of 5% over the course of the next decade; I expect as the company grows and gains a solid footing, as the macro environment improves and consumer spending reaches pre-pandemic enthusiasm, as the competition from traditional banks (Zelle, etc.) grows, and as current FinTech and other non-conventional competitors get a strong foothold as well as new entrants such as Remitly and TapTap enter the market, it will become a sweet and sour journey for the company's transactional revenues. Transaction revenues should see a gradual decrease due to saturation and other risks involved with the business that will be partially offset by the company's brand, scale, risk and compliance management and its ever touted two-sided network. 
• Revenues from other value added services: These are revenues earned and derived primarily from revenue earned through partnerships, referral fees, subscription fees, gateway fees, and other services the company provides to merchants and consumers. Revenues or income earned on company's portfolio of loans receivable and certain assets underlying customer balances are also included in this category. This category, as we can see from the historic income statement above, is an insignificant part of the overall revenues, but it has been improving over the course of the last five years; company reported this category at 9.8% of total revenues for FY '23, and I am assuming that as the company's transactional revenue (driven by an increase in TPV and active merchant and consumer accounts) grows, this section inflates along with it. I expect this category to grow at a CAGR of 15.6% over the course of the next decade and the reasoning for the increase is self-explanatory; as the company's transactional revenues dwindle- for reasons stated above- I expect the company to invest more in this category and derive more value from their relationships with consumers and merchants through existing and new value-added services. 
• Costs: PayPal reports a number of operating and non-operating expenses; on its 2023 10K, company reported transaction expense of $14B (48% of NR), transaction and credit losses of $1.7B (5.6% of NR), customer support and operations expense of $1.9B (6.4% of NR), sales and marketing expense of $1.8B (6.1% of NR), technology and development expense of $2.9B (10% of NR), general and administrative expense of $2B (6.9% of NR), and other miscellaneous and restructuring charges of $-84M. I will not go into the details of what each of the expense category entails for two reasons: firstly, they are pretty self-explanatory, and secondly, it will extend this post beyond the limits; suffice it to say, I have read what they all entail and I think that all of their relationship with the top-line will be similar, and as such, I will forecast this category as an amalgam of all of the expenses. For the next 5 years, as the company fights for its survival, I expect these expenses to mildly increase in order to retain its current market position and possibly even attain new business and consumer accounts. For the following 5 years, I expect the company to have achieved a strong foothold within the industry that will lead to lower costs which will be commensurate with lower revenue growth.    
• Operating income and margins: As is evident from the screenshot pasted above, PayPal reported operating margins of 16.8%, 13.9%, and 16.9 for the FYs '21, 22, and '23, respectively. For my base case, I expect margins to be lower for the next 5 years driven by stagnant top-line growth and higher expenses, but as the company reaches the stability phase, I expect margins to increase to 37% by the end of FY '33-driven by lower growth in revenues and even lower expenses. For my best case, I expect operating margins to be around 42% by the end of FY '33, and for my weak case, I am expecting operating margins of 31% by the end of the projection period. I will explain the impact of all three scenarios when we get to the valuation section. With my revenue, cost and operating income assumptions, here is what my going forward income statement looks like in my base case:
  
  
  
• Capex and depreciation and amortization: Historically speaking, PayPal is not a capex intensive business and so the company reported capex of $908M (3.6% of NR), $706M (2.6% of NR), and $623M (2.1%) for FYs '21, '22, and '23, respectively. I expect capex to be roughly around 2% in order to sustain the revenue growth for the entire projected period. Depreciation and amortization (combined for PP&E and intangible assets) was 3.6% of net revenues for FY '23, going forward, I expect D&A to gradually decrease as a percentage of not only revenues but also capex, I am not projecting a one-for-one change by the end of the projection period because that will make my 3% growth in perpetuity impossible to achieve, because to grow, companies have to invest. Here is what the PP&E and D&A schedule looks like:
  
  
  
• Treasury stock and share repurchases: PayPal, at least for the observed period, has consistently been returning cash to its shareholders in form of share repurchases; company reported share repurchases of $5B (24% of NI) for the latest reported year, and since share repurchases are solely to the discretion of the company and its management, I don't think that there is a plausible way for me to project this, but I will assume that the company will payout the same percentage of its NI (24%) for the entire projection period. Here is what the treasury stock schedule looks like for me:
  
  
  
• Retained earnings: I expect retained earnings balance to increase from $23B in FY '23 to $76B in FY '33, driven primarily by the incremental increase in NI. The company does not have a history of paying dividends, but I assume as its retained earnings balance inflates, PayPal might decide to enhance shareholder value through dividends as well as share buybacks; I expect the company to start paying dividends sometimes in the next 6 years with an initial dividend payout ratio of 6% for FY '29 and gradual increase to 30% by the end FY '33. Here is what the retained earnings account looks like:
  
  
  
•  EPS (basic and diluted): Moving on to one of the most pivotal metrics that investors care about, PayPal reported basic EPS of $3.85 and diluted EPS of $3.84 for FY '23. I expect company's EPS (both basic and diluted) to decrease over the next 5 years due to mild growth in revenues and associated high expenses; but, as the company gains a foothold, I expect EPS (both basic and diluted) to increase to $14.84 by the end of the projection period. EPS schedule is pasted below.
  

• Working capital: PayPal's working capital does not follow a trend with the company reporting wildly fluctuating net working capital margins over the course of the last 5 historic years, and so to be conservative, I have taken the latest margins of 4.3% and straight-lined it for the entire projection period. I know some of you might think it to be callous, but I think better this than to predict a line item with no visible and comprehensible connection to revenues or anything else. 
• Balance Sheet: With all of the line items explained, I think we should now look at what the going forward balance sheet might look like for PayPal. 
  

• Cash Flow Statement: I have not included the historic cash flow statement in the snapshot below for two reasons: firstly, cash flow statement is simply a YOY reconciliation of the balance sheet line items, and secondly, last year's cash flow statement and changes are captured in the cash balance. Here is what the going forward cash flow statement looks like:
  
  
  
• Ratios and Metrics: I, for one, do not put too much stock in ratios of any kind, but I know there are people out there that are more analytical and savvy than I am who do, and for those poor souls, here is what I think various ratios might look like for PayPal over the next decade. 
  
  
  

Valuation

I think that we are now at a tactically sound position to value PayPal. Before I share my valuation of PayPal, I believe just like above, I should go over some overarching assumptions and why I made them. 

Assumptions:

• WACC: In order to compute PayPal's WACC, I needed its cost of debt and instead of taking the yield on a bond the company issued a year ago as its pre-tax cost of debt, I decided to look at its debt balance over the last 5 years. I came across a footnote in its 10K that listed out all of its issuances and the accompanying yields for the last five years, and so I decided to take the weighted average of all the past issuances, which gave me a pre-tax cost of debt of 3.06%, which after tax comes out to 2.29%. For its cost of equity, the company has a beta of 1.44, the market risk premium as of this analysis was 4.18%, and the risk-free rate was 4.24%, yielding a cost of equity of 10.26%. With the company's weight of equity of 109.6% and weight of net debt of -9.6%, we get a WACC of 11.02%. I am assuming 11.02% for the entire projection period, and have accounted for anomalies or variations in the sensitivity analysis. 
•  Perpetuity growth: Perpetuity growth rate is one of the integral part of valuations, and given that the going concern lives rent free in my head, I am assuming that PayPal will grow at a 3% growth rate into perpetuity. I have accounted for this growth in my assumptions for capex and reinvestment, because like I mentioned somewhere else in this post, to grow, companies must reinvest. 
• EBITDA multiple: In all of my previous works, I refrained from using the EBITDA multiple approach for valuation because I believe it taints the very essence of intrinsic valuation: intrinsic valuations are about the companies intrinsic value, cash flows, risk, and cost of capital, and when we bring in an EBITDA multiple, we impose market assumptions onto the company, which ends up being a pricing exercise rather than an intrinsic valuation. But, I decided to use it for this analysis for sanity reasons. I have assumed an EBITDA multiple of 8x, which is lower than the implied EBITDA multiple of 9.12x I got through the perpetuity approach; 8x is an entirely arbitrary number and I did not get that multiple from any of the data aggregators as I do not have access to them, so if you are not comfortable with that multiple, feel free to change it. With all of these assumptions, and assumptions made in the previous section. here is what I believe the true value of PayPal is in my base case: 

As you can see, in my base case, I get a share price of $98.35; the stock was trading at $66.71/ share as of this analysis, it is without a doubt undervalued. Given my WACC of 11.02% and perpetuity growth rate of 3%, I get an implied EBITDA multiple of 9.12x, but I assumed an EBITDA multiple lower than than the implied multiple simply for conservatism; I get a price per share of $90.14 assuming an EBITDA multiple of 8x. As is the case with all valuations, whether they are conducted by yours truly or anyone else, they are subjective works and are entirely dependent on what the person thinks will happen to the company in the future. My job here is to convince you of my findings and my vision of the future, and so to that end, I am also sharing various sensitivity analyses that I ran. 

Sensitivity

I have mentioned multiple times throughout this post about results being in base case, but I do also have the results for my best and weak cases. Everything in this post thus far has been in my base case, unless otherwise notated, and so I think that I should also give you the end results for my other scenarios to further solidify my findings. I will not go into details as to what I think about revenues and costs or other items in best and weak scenarios, I will leave that to your curiosity and my Excel file, I will instead mention the end results: in my best case, I get a price per share of $121.15, and for my weak case, I get a price per share of $77.28, to reiterate, PYPL was trading at $66.71 per share, which further strengthens my view that the stock is undervalued. Lets now look at how susceptible price per share is to changes in various variables. 

Images 1 and 2 show the relationship between WACC, long-term growth rate and EBITDA multiple. I mentioned before that I assumed a WACC of 11.02% for the entire projection period and so I wanted to see the price per share for other levels of WACC, and as you can see in image 1, if I assume the same TGR but a lower WACC, say 9.22%, I get a price per share of $135.47, and if I assume a WACC higher than 11.02%, say 12.02%, I get a price per share of $83.78. Image 2 tells a similar story, it shows the relationship between WACC and EBITDA multiple; I especially wanted to see the impact of changes in my EBITDA multiple assumptions because as I mentioned before, my multiple of 8x is an arbitrary number and to give it some semblance of credence, I wanted to look at the price per share at the same WACC but different multiples. As you can see, if I assume a WACC of 11.02% but a multiple of 7x, I get a price per share of $82.83, and if I assume a higher multiple, say 9x, I get a price per share of $97.45. I also looked at the impact of changes in operating margins, revenues, WACC, and EBITDA in FY '33, the results are down below and I'll let the numbers speak for themselves.  

Conclusion

It is entirely possible that you don't agree with any part of this valuation and for that reason, I have attached my Excel file below for you to inspect and dissect, and hopefully, you will reach the same inevitable conclusion that I did: PayPal is undervalued. I for one, will be incorporating PayPal in my portfolio as I sternly believe in the future that I have laid out for the company, and for you, I leave the decision in your capable hands. 

Links:

PayPal Valuation- 04/03/2024

PayPal 2023 10K