- PayPal will acquire international money transfer services provider Xoom for $25 per share in an all-cash deal
- The current valuation of Xoom seems to greatly discount its growth opportunity meaning PayPal is getting Xoom at a cheap price.
- It makes good sense to buy eBay shares before PayPal spinoff
Leading online money transfer service provider, PayPal (Pending: PYPL), has reached a definitive agreement to acquire money transfer services provider Xoom (NASDAQ:XOOM) for $890 million just days before PayPal officially breaks apart from eBay (NASDAQ: EBAY). The buyout will be consummated in an all-cash deal worth $25/Xoom share, or a healthy 32% premium to Xoom’s 3-month weighted price. Even though online business accounts for roughly 5% of Western Union’s (NYSE: WU) revenue, it has been driving nearly half of the company’s top line growth and WU shares have consequently sold off by about 9% since details of the merger hit news feeds due to the threat posed by a combined PayPal-Xoom entity. PayPal will start trading publicly on 20th July 2015. The company will receive a $5 billion cash handout from eBay, so presumably the Xoom deal will be financed from this cash. Will PayPal receive a higher valuation after acquiring Xoom?
Xoom finished the first quarter with revenue of $44.4 million, representing 24%Y/Y growth and Gross Sending Volume, or GSV, of $1.7 billion, representing 6% Y/Y growth. In comparison, PayPal did $61.413 billion in Total Payments Volume, or TPV, during the first quarter which was good for 18%Y/Y growth while its revenue clocked in at $2.14 billion. Xoom’s business is therefore about 2% the size of PayPal’s business.
The first thing that strikes you as rather odd about Xoom’s results is the fact that the company’s GSV increased only 6% but the company still managed to post a healthy 24% increase in revenue. Looking at Xoom’s 2014 results, you notice that this year’s growth numbers were nowhere nearly as impressive as those in the previous years. In first quarter fiscal 2014, Xoom’s revenue and GSV grew 48% and 49% respectively. So why the sudden slowdown? Is the market opportunity for Xoom drying up?
I strongly suspect the major reason why Xoom saw a rather dramatic slowdown in growth can be chalked up to a significant hike in the company’s rate of commissions charged on transactions, also known as the take rate in the payment business. In the first quarter of 2014, Xoom’s take rate (Revenue ÷ GSV) clocked in at 2.24%. During the last quarter, Xoom’s take rate increased to 2.61%. In other words, Xoom hiked its commissions charged on transactions by a rather hefty 16.5% in one year. This appears to be counterintuitive since increasing competition leads to pricing pressure which forces leading players to lower their rates to remain competitive. In fact, PayPal’s take rate has been consistently coming down gradually over the years due to intense competition in the space.
Xoom’s 6% GSV growth was actually below the projected market growth rate of 8%, which suggests that the decision by the company to hike its take rate was ill-informed.
Source: Company Presentation
It’s plausible that Xoom hiked its take rate in an effort to snap from its loss-making streak. But, after getting integrated with PayPal, the company’s operating expenses will be taken care of by PayPal which is a solidly profitable business. This will allow Xoom to lower its take rate to more favorable levels and start growing its GSV at much higher clip than it did during the last quarter.
Now let’s try to address the question of whether Xoom can potentially increase PayPal’s valuation. Xoom currently sports a market cap of $977.4 million and a PS ratio of 5.83. PayPal started trading on Monday on a ‘‘when issued’’ basis that gave the company a valuation of $44 billion, or about $36.35 per share going by current eBay price. Using PayPal’s first quarter revenue, PayPal trades at a PS ratio of 5.14, which makes Xoom’s shares rather expensive.
PayPal sports an operating margin of 21%, lower than Marketplace’s 37% operating margin. eBay does not break out the net margins for either segment but we can use the respective operating margins to arrive at approximate net income figures for each segment. eBay finished the first quarter with net income of $626 million, or $2.504 billion annualized. Using the respective operating margins of Marketplace and PayPal we arrive at $906.6 million as PayPal’s annualized net income. This gives PayPal a PE ratio of 48.53. Since Xoom’s shares are already quite expensive relative to PayPal’s, the upside that will result from the integration might only be limited to the resulting synergies between the two businesses and the fact that PayPal will now gain a good foothold in the international money transfer business. I project the market may decide to give PayPal a slightly higher PE of maybe 51.5, or about $38.77 per share.
eBay shareholders will receive one PayPal share for every eBay share they hold. Supposing eBay stock trades down to fully reflect the loss of income after the PayPal spinoff, they would trade at $39.54. This means that an eBay investor will be left holding one eBay share and one PayPal share after the spinoff worth a combined $78.31, or a 28.4% net gain over current eBay price (as of July 8 close). It’s important to note it’s not very likely that eBay shares will trade down by such a large margin after the spinoff so the potential gain could be much higher than what is stipulated here. It therefore makes good sense to buy eBay shares before the spinoff.
Note: You might also be interested in our eBay stock analysis video.