One acquisition that analysts have talked about is Apple buying PayPal especially since Apple Pay was introduced in October 2014 with the iPhone 6 and 6 Plus and Touch ID. It can also be used on the iPhone 5, 5c and 5s when paired with an Apple Watch but lacks Touch ID security. PayPal has been a standalone company since it was spun out of eBay in July 2015 and the stock has been on a tear this year rising 85%. This note looks at the combined companies bottom line. I’ve also done the same analysis of Apple buying Netflix in a previous article. (Note that I own Apple shares and have sold Put options, a bullish strategy).
There are strategic reasons that this acquisition would make a lot sense due to PayPal’s strong position in electronic payments. To look at it from a financial perspective I’ve built a model for the combined companies with projections into 2020. I’ve downloaded it into a Google Doc that is available via this link so that you can see my assumptions and the results.
The first set of assumptions are for Apple’s and PayPal’s revenue, gross margin, operating expense ratio, other income, interest expense, tax rate and share count three years out from Apple’s fiscal 2017 and projecting PayPal’s 2017 based on its first three quarters this year.
The second set is the premium Apple will have to pay above PayPal’s current stock price (I’m using 20%) and how Apple pays for it using debt and/or stock. I’ve run three cases with 100% equity, 50% debt and equity and 100% debt. I’ve also estimated how much additional revenue PayPal could generate since it would have access to Apple’s financial resources, how much savings there could be in operating expenses and how much of a hit Apple’s shares could take when the acquisition is announced. These provide EPS estimates and can be compared to a three year base case if Apple does not buy PayPal.
Obviously making multi-year projections is imperfect and more cases than the ones I have done would be run by an acquirer. However the results at least provide some insight into what the financial ramifications would be with the merger.
Apple assumptions to 2020
Apple is a slower growth company than PayPal and has a longer history to make some rational projections. However Apple’s iPhone hit driven revenue stream makes longer term projections harder. That being said these are my assumptions over three years.
- Average revenue growth of 8% per year
- Gross margins decrease from 38.5% to 38.0%
- Operating expenses as a percent revenue rise slightly from 11.7% to 12.0%
- Operating margin falls from 26.8% to 26.0%
- Other income increases from $2.7 to $3.5 billion per year
- Tax rate increases slightly from 24.6% to 25.5%
- Share count decreases by 3% per year
When you run these assumptions Apple’s EPS increases from $9.33 in fiscal 2017 to $11.89 in fiscal 2020. So the $11.89 of EPS becomes the baseline to compare buying PayPal.
PayPal assumptions to 2020
PayPal assumptions have a higher degree of difficulty due to it being a younger and much faster growing company. Besides growing faster it is harder to determine how much earnings leverage the revenue growth could provide since its gross margin (transaction expense and transaction & loan losses) is decreasing while its operating expense ratio is declining. These are the assumptions I am using for the next three years.
- Average revenue growth of 20% per year (estimated 19% in 2017)
- Gross margin declines from 59.1% in 2016 to 56.0% in 2017 to 52.0% in 2020
- Operating expenses as a percent of revenue falls from 39.1% in 2016 to 35.0% in 2017 to 31.0% in 2020
- Operating margin goes from 20.1% in 2016 to 21.0% in 2017 and stays flat to 2020
- Other income increases from $45 to $100 million
- Tax rate increases from 17.9% in 2016 to 18.7% in 2017 to 20.0% in 2020
As a point of reference if PayPal’s share count increases 1% per year (it is projected to increased by 0.8% in 2017) then its EPS would increase from $1.50 in 2016 and $1.84 in 2017 to $3.03 in 2020. At the current stock price its 2020 PE multiple would be 24.1x vs. the current 39.6x.
Combined companies financials
When you smash together the two companies the first item to notice is that PayPal’s revenue is only 7.2% of the two companies in 2020. Next is that the combined companies margins are very close to Apple’s. Below are Apple’s standalone margins in fiscal 2017 to the combined company in three years.
- Apple’s gross margin increases slightly from 38.5% in fiscal 2017 to 39.0% for the combined companies
- Operating expense ratio moves from 11.7% to 13.4%
- Operating margin declines slightly from 26.8% to 25.6%
- Net margin declines from 21.1% to 20.0%
These are two additional estimates for the combined companies
- 20% leverage on PayPal’s 2017 revenue in 2020 due to Apple’s resources
- 10% less on PayPal’s operating expenses due to combining operations
Comparison to Apple’s standalone EPS
PayPal’s market cap is currently $89 billion so if Apple pays a 20% premium it will have to come up with $107 billion. The company has a net cash balance of $6.2 billion as of September. I assume that 90% of the net cash could be applied to the purchase price or $5.5 billion just to be a bit conservative.
The following results are based on Apple’s closing price of $169.37 on Friday minus a 5% hit if the company were to buy PayPal. PayPal’s price on Friday was $72.91 with a take out price of $87.49.
100% Equity option
- Saves over $200 million per year in interest cost due to PayPal’s cash
- Needs to issue 666 million shares
- Generates $11.21 in EPS vs. the baseline $11.89
- This is 5.7% below the baseline
50% equity/50% debt
- $48 billion in debt cost $1.9 billion per year at 4%
- Needs to issue 333 million shares
- Generates $11.50 in EPS vs. the baseline $11.89
- This is 3.3% below the baseline
0% equity/100% debt
- $102 billion in debt cost $4 billion per year at 4%
- No impact to the share count
- Generates $11.83 in EPS vs. the baseline $11.89
- Is very slightly dilutive at 0.6% compared to the baseline EPS
While an all debt deal provides the best result even the 50% equity/50% debt option isn’t too far off from being EPS neutral. Since there could be additional non-financial benefits buying PayPal makes sense.
