After years of strained relationships between itself and the major payment networks, PayPal Holdings Inc (PYPL 1.57%) finally reached groundbreaking multiyear deals with both Mastercard Inc (MA 0.96%) and Visa Inc (V 1.17%) last year.
Image source: PayPal Holdings Inc
According to both deals, PayPal will allow consumers to choose their Mastercard and Visa credit cards as a preferred option of payment. PayPal also agreed to share data with the credit card companies and their card-issuing banks. In return, PayPal's digital wallet will be accepted wherever Mastercard or Visa contactless payments are accepted at physical retail locations.
PayPal CEO Dan Schulman defended these deals because they offer PayPal customers more choices in an effort to prioritize customer needs. In PayPal's 2016 third quarter conference call, Schulman stated:
Being a customer champion means always prioritizing the needs of our customers. ... By making customer choice a priority for PayPal, we are creating a significantly better customer experience to accelerate adoption and drive engagement.
The concerns over transaction and operating margins
Wall Street didn't seem to know how to process the deals. When the Visa deal was announced, PayPal's stock dropped about 10% the following month, despite reporting solid earnings for the quarter. Yet a month and a half later, when Mastercard announced its deal with PayPal, PayPal's stock price quickly recovered and even reached new all-time highs.
The primary concern surrounds PayPal's transaction and operating margins. PayPal's transaction margin is the percentage of transaction revenue it keeps after subtracting costs like third party payments and loan losses. Operating margin is a measure of how much of a company's revenue is left over (known as operating income) after paying for operating costs like employees' salaries.
Since the beginning of 2014, PayPal's transaction margin has slowly, but steadily, declined, from 65% in 2014's first quarter to 58.7% in their most recently reported quarter. PayPal's operating margin (non-GAAP) was 18.4% in this year's third quarter. That is down from 19.9% in the same year ago period.
Many analysts believe this problem will only be exacerbated with the recent Mastercard and Visa partnerships. After all, facilitating transactions over Mastercard's and Visa's networks is less profitable for PayPal -- due to extra processing fees -- than using the ACH (Automatic Clearing House) network.
Should PayPal investors be worried?
In response to these concerns, it should be noted that there are several legitimate reasons for the decline in PayPal's margins. To begin with, the international remittance company Xoom, which PayPal acquired in 2015, is not yet profitable. PayPal projects this to change in the coming year. In addition to Xoom, the growth of Braintree, PayPal's subsidiary specializing in mobile and web payment systems for e-commerce companies, has driven the company's transaction margins down. Braintree has a lower take rate -- which is the revenue the company generates as a percentage of total payment volume -- and higher transaction costs than PayPal's core platform. Finally, PayPal's peer-to-peer (P2P) payments business, including the Venmo app, drives down the company's transaction take rate.
Schulman clearly recognizes the huge opportunity lying ahead for PayPal as e-commerce continues to grow at double digit rates. The Census Bureau recently stated that for the first time ever, e-commerce sales could represent more than 10% of all retail purchases this quarter.
Schulman believes the total market is so large that continued investment in PayPal is a must in order to capture future market share. He sees the company's recent Mastercard and Visa deals in this light, vowing that PayPal will not be a "slave to margin performance" from quarter to quarter if it comes "at the expense of investing in the business." Despite this, Schulman also called for margins "to be stable to growing over time." Even more encouraging for concerned PayPal investors, in a recent interview on CNBC's Mad Money, Schulman stated the early results of the partnerships were encouraging and could exceed expectations.
The big takeaway
In a world where consumers can order and pay for a latte on an app twenty minutes before picking it up at the local coffee house, the line between e-commerce and physical retail continues to blur. PayPal management believed it was of primary importance to gain a greater foothold in the brick-and-mortar world. The Mastercard and Visa deals decisively accomplished this.
It should also be noted that despite PayPal's falling operating and transaction margins, the other numbers and metrics across PayPal's universe continue to shine. Revenue rose 18% and non-GAAP EPS grew 14% year over year in PayPal's 2016 third quarter. The number of active accounts reached an all-time high of 192 million, an 11% increase year over year. Payment transactions per active account were up 13% year over year.
| PayPal Holdings Inc Metrics | 2016 Q3 | 2015 Q3 |
|---|---|---|
| Operating Margin (non-GAAP) | 18.4% | 19.9% |
| Transaction Margin | 58.7% | 62.3% |
| Net Revenues (millions) | 2,667 | 2,258 |
| EPS (non-GAAP) | $0.35 | $0.31 |
Data source: PayPal Holdings Inc quarterly earnings press release
Given PayPal's track record of growing revenues and earnings, managements guidance for stable to growing margins, and the growing market of online sales, PayPal investors should not be spooked by the company's falling margins. The numbers bear watching, of course, but as long as revenue and earnings continue to climb, active accounts continue to grow and margins remain relatively stable going forward, PayPal investors should be rewarded for their patience.
