PayPal Holdings (PYPL -1.85%) is riding the big wave of mobile payments adoption, but there has been one risk lurking underneath the surface: its PayPal Credit product, and the potential swings in earnings that could come from a downturn in the credit cycle. The more important issue in the short term, however, is that PayPal's credit business ties up nearly half of its annual free cash flow. With the opportunity in mobile payments wide open, management has plenty of other things they can do with that cash.

After about a year of searching for answers, management found a solution to this problem. In a deal valued at $6.8 billion, Synchrony Financial will acquire PayPal's U.S. consumer credit receivables portfolio. In exchange, PayPal will receive approximately $6 billion in cash and will also have a profit-sharing agreement with Synchrony. The deal is expected to close in the third quarter of 2018, and could potentially accelerate PayPal's momentum toward reaching $1 trillion in total payment volume.

A smartphone lying on a desk with the PayPal app displayed and a credit card and other items positioned around the smartphone.

Customers who use PayPal Credit are 50% more engaged than the average PayPal customer. IMAGE SOURCE: PAYPAL HOLDINGS 

What to expect in the short term

The deal is expected to cut a few percentage points off of revenue in 2018, according to management's updated guidance. Previous guidance called for 2018 revenue growth of 20%, but that number has been reduced to about 16.5%. However, management noted that if the Synchrony deal had been in effect starting at the beginning of 2016, compound annual revenue growth from 2016-2018 would still be 20%.

Management still expects non-GAAP operating income to grow 20% in 2018. There is also no change to 2018 guidance of mid-to-high 20% growth in total payment volume.

The profit-sharing agreement with Synchrony means that PayPal will still benefit from the growth of customers using PayPal's credit product, but the risk and cash burden associated with funding credit will be shifted over to Synchrony.

PayPal will now be able to focus even more on capitalizing on the megatrend of digital payments.

PayPal frees up $1 billion in annual free cash flow

PayPal management had been working toward de-risking its balance sheet over the last year. As PayPal grew larger, the growing credit portfolio was becoming more of an issue. PayPal's U.S. consumer credit portfolio makes up about 2% of its total payment volume, and almost 10% of expected 2017 revenue.

Growing revenue from credit loans is a good business when the economy is doing well, but a downturn in the credit cycle would likely cause a jump in loan losses, putting a dent in PayPal's earnings. Consumer credit is also highly capital-intensive, tying up 40% to 50% of PayPal's annual free cash flow.

The Synchrony deal frees PayPal from the burden of these cash outflows. When the deal closes later next year, management will have an extra $1 billion in free cash flow available annually to reinvest in the core business, as well as potentially return it to shareholders via share repurchases. Acquisitions and dividends are also possibilities.

More capital to invest in new features could go a long way

A centerpiece of management's growth strategy is focused on increasing customer engagement as measured by the number of transactions per customer account, which has been consistently growing around 10% year over year. This metric is half of the equation of growing total payment volume -- the engine that drives revenue and earnings growth.

Features like One Touch and partnerships with other payment leaders have played a key role in increasing the frequency that customers use their account, which is currently about once every two weeks. As management directs more capital to the customer experience and the development of new features, the resulting increases in this frequency could provide a significant benefit to shareholders over the long term.

As I explained in this November article, all else being equal, PayPal's total payment volume will increase at about the rate that transactions per account increase. If customers used their account twice per week (which is management's long-term goal), PayPal's annual total payment volume would triple to over $1 trillion even if customer accounts and amount per transaction stay the same. Revenue would also increase about the same rate.

The market response has been muted since the Synchrony announcement in November. That's likely because the benefits of this deal won't come for almost another year, which is an eternity to Wall Street. Plus, there's some uncertainty as to exactly how management will allocate the cash, but management affirmed on a conference call with analysts that they do intend to use this influx of cash as an opportunity to invest in driving higher customer engagement.

The benefits of the Synchrony deal won't come overnight, but this has huge ramifications in the years to come.