(Oct 7): We have made three recent additions to the Global Portfolio. PayPal Holdings and Square are fintech companies while ServiceNow (NOW) is a Software as a Service (SaaS) company.
The online and mobile payments industry will continue to gain from several long-term structural trends. That includes the secular shift from offline to online-mobile commerce and from cash to a cashless society, driven by the ubiquity of smartphones that is also, for the first time, folding the world’s unbanked and underserved population into the global financial system. PayPal and Square are players in this space, competing to be the new generation of financial service providers.
Another major structural trend is the shift from on-premise infrastructure, hardware and software to subscription-based cloud services accessed via the internet. Again, we see tremendous growth prospects in this still-nascent sector. We had previously bought Adobe and have added NOW to our portfolio.
Tech stocks are going through a bit of a rough patch currently, owing partly to valuation concerns — especially in the light of the poor performances by unicorn tech IPOs such as Uber and the unravelling of WeWork’s proposed listing. We wrote about this last week.
Valuing tech companies is never easy, especially those that are loss-making but have strong top-line growth — resulting in higher-than-market-average risks. That said, we believe the underlying structural trends are real, which will translate into significant long-term gains. There will be big winners — and, yes, losers — within each sub-segment.
PayPal
We like PayPal for its strong recognisable brandname and dominant market positioning. The company has come a long way from its early days as the preferred online checkout for eBay to become a major player in the fast-growing online and mobile payment service space.
Thanks in part to its first-mover advantage, PayPal has accumulated a huge customer base globally, comprising businesses and merchants as well as consumers. One of its more recent acquisitions, Venmo, is currently among the most popular digital wallets for peer-to-peer (P2P) money transfer in the US.
As mentioned, PayPal will benefit from the transition from offline to online-mobile commerce and cash to cashless payments. Its long-term growth potential includes tapping into the 1.7 billion unbanked individuals, of which 60% to 70% own a mobile device, and offering a range of financial services to these people currently underserved by traditional financial institutions.
PayPal delivered a solid set of 2QFY2019 earnings results. Revenue grew at a healthy double-digit clip of 11.6% y-o-y to US$4.31 billion ($6 billion) and non-GAAP (Generally Accepted Accounting Practices) earnings per share grew 47% to 86 US cents. It achieved satisfactory results in three main key performance metrics: active customer accounts, payment transactions and total payment volume (TPV).
There were some nine million net new active accounts in 2QFY2019, up 17% y-o-y, bringing total active accounts to 286 million. Payment transactions per active account, on a trailing 12-months basis, rose 9% to 39. Both factors boosted total transactions processed to three billion during the quarter, up 28% y-o-y.
Meanwhile, TPV rose 24% y-o-y to US$172 billion in the quarter, of which mobile payments grew an outsized 37%. TPV for Venmo was up 70% y-o-y to US$24 billion, though missing market estimates of US$28 billion.
Investor sentiment was dampened, however, by its lowered revenue guidance for the full year. Management attributed this to delays for several complex partner integrations, from 3QFY2019 to year-end. The company also delayed the implementation of some pricing revisions to better coincide with service enhancements.
Looking ahead, PayPal will reach the end of its arrangement with eBay in 2020. While this will hurt revenue contributions, it will also open the door to partnerships with other e-commerce platforms (previously restricted under the agreement) such as MercadoLibre.
MercadoLibre is the leading e-commerce player in Latin America, commanding about 50% market share. Earlier this year, PayPal invested US$750 million in the platform and another US$500 million in Uber. These are strategic partnerships aimed at widening the company’s addressable market globally.
PayPal has a strong net cash position and generated free cash flow totalling US$15.2 billion for the past seven years, including US$4.7 billion last year.
Square
Square operates in the same industry as PayPal, but on a much smaller scale. In 2018, it processed US$84.7 billion in gross payment volume (GPV). The company is still in the red. That makes it harder to value and this is underscored by the diverse analyst recommendations and price targets, as well as greater volatility in its share price. It is growing its top line much faster than PayPal, however, owing partly to its low base effect. This stock is a riskier bet but with strong potential returns.
Square started in 2009, primarily to enable smaller merchants to accept credit card payments at point of sale — with a reader that plugs into any mobile device (tablets or smartphones), used in conjunction with its app. It has since expanded to the consumer-facing, mobile wallet segment.
The Cash App (similar to PayPal’s Venmo) is an important driver for future growth, with features such as Cash Card, direct deposits/payroll, cashback at partner merchants (Boost), Bitcoin trading and, of course, P2P money transfer.
Currently, Square generates most of its income from the US while there are ongoing efforts to penetrate markets such as Canada, Australia, Japan and the UK.
Sales are classified into four main segments — transaction-based, subscription and services-based, hardware and Bitcoin trading.
The transaction segment contributes 67% of the company’s revenue and is based on GPV processed by sellers using its reader-app. Square charges sellers a transaction fee for managed payments solutions, generally a percentage of the total transaction amount.
The subscription and services-based segment accounts for 22% of revenue and comprises Instant Deposit and Cash Card, Caviar (food delivery and catering business), Square Capital (business and consumer financing), website hosting and domain name registration services, and various other SaaS products. The remaining revenue is derived from Bitcoin trading (9%) and sale of hardware (2%).
It recently sold Caviar to DoorDash for US$410 million. The proceeds will be reinvested to grow its core business. Notably, Square reported positive free cash flow for the past two years and in 1HFY2019. This bodes well for funding future expansions.
Square plans to increase spending on product innovation, sales and marketing for both the merchant and individual portfolios, as well as more effective bridging of the two ecosystems. The downside is that efforts to turn a profit could take a backseat for now.
Square’s 2QFY2019 earnings results were mixed — it beat expectations on earnings and revenue but missed on GPV, for the third straight quarter. More significantly, its shares fell sharply on the back of a weaker outlook and guidance. Nonetheless, we believe the company’s long-term growth prospects are intact.
The ratio of total net revenue to payment volume is rising, which suggests that add-on services and software services are doing well among merchants, for example real-time data analysis, e-commerce, business financing and payroll. The new Square Card (a business debit card) could deliver 5% to 10% of revenue by 2022, based on its current adoption rate of 10% of merchants, whose spending on the card equates to 20% of their sales, according to the company.
Another key growth driver would be to provide merchant advertising to Cash App users through Boost reward and Square Installments programmes. Cash App reported about US$135 million revenue in 2QFY2019 and has more than 15 million active users. There are reports that Square plans to expand its investing platform, from Bitcoin to include stock trading.
All of the above are part of its strategy to improve stickiness, market positioning, enlarge the addressable market and, ultimately, offer customers a one-stop financial services platform.
ServiceNow
NOW is a cloud-based enterprise software company that helps businesses digitise and automate workflows. Basically, it offers a simple yet powerful cloud platform that consolidates all IT processes within an organisation. Key features include IT helpdesk set-up, new hire onboarding, customer request tracking and financial planning analysis. It is the second-largest pure play SaaS vendor by revenue behind Salesforce. The latter delivers a digital cloud platform that focuses more on customer engagement.
In July, the company opened up a key growth channel by partnering with Microsoft — using Microsoft Azure cloud to host workloads for the US and Australian governments. In return, Microsoft will sell NOW applications to their infrastructure cloud clients. A similar pact was made with Google Cloud a month earlier. These strategic alliances with Infrastructure as a Service (IaaS) market leaders will fuel NOW’s growth in the growing cloud application industry.
The global enterprise software market is forecast to grow 8% annually to 2023 — underpinned by big data analytics and cloud computing, growing demand for business intelligence and analytics, and increasing adoption of database management systems.
Thus, we believe NOW’s top-line growth is sustainable at around 30% annually, as more large enterprises and government agencies transition to cloud-based solutions and automation. This clientele is, generally, more insulated from a macroeconomic slowdown. Indeed, the need to automate work tasks towards leaner, more efficient operations becomes even more crucial in recessionary times.
Subscription, which makes up 94% of sales, saw strong growth momentum in 2QFY2019, up 32% y-o-y. The steady increase in large orders (above US$1 million) adds to revenue visibility and provides a tailwind to a better operating margin. That said, the company might well sacrifice bigger short-term profitability gains for longer-term market share, with more aggressive hiring and investments in new products.
Key growth levers include high existing customer renewal rates of 98%, broadening of distribution channels and increasing contributions from newer products such as security, HR, customer services and business applications.
The strategic nature of NOW’s singular, fully integrated product suite ensures high switching costs and stickiness while also creating more upselling opportunities — to further automate other unstructured workflows.
NOW could be on the cusp of turning a profit. Quarterly net losses have narrowed, from US$52 million in 2QFY2018 to US$11 million in 2QFY2019, while earnings before interest, taxes, depreciation and amortisation grew from US$3.2 million to US$33 million over the same period. A successful turnaround is likely to boost investor confidence in, and appeal for, the stock.
Next week, we will provide a layman’s guide to investing in tech companies — why some fail while others are super successful, and what drives their valuations.
The Global Portfolio fell 2.8% last week, in line with the decline in the MSCI World Net Return Index. This pared total portfolio returns to 7.3% since inception. Nevertheless, the portfolio continues to outperform the benchmark index, which is up 4.5% over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
