Why PayPal's Deal With Visa Overshadowed Earnings

By Markets Fool.com

Image source: PayPal Holdings Inc.

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Global digital-payments provider PayPal Holdings Inc's (NASDAQ: PYPL) second-quarter 2016 earnings report, issued July 21st, should have, by all rights, pleased shareholders. PayPal reported brisk revenue and earnings growth, and raised guidance for the remainder of the fiscal year.

Yet shares traded down in the session immediately following the earnings filing, and have lost roughly 9% since the earnings report to date. Investors honed in on, and are still grappling with, a new partnership announced with Visa Inc. (NYSE: V) alongside Q2 earnings. Below, we'll review highlights from PayPal's second-quarter report, and delve into the details of the Visa agreement, to understand why PayPal shares have recently given up ground.

A quarter of continued momentum

PayPal's management cultivates a few vital metrics to ensure profitable growth, and each of these metrics exhibited relative health in the second quarter. Total Payment Volume, or TPV, which measures the dollar value of payments transacted over the company's payments platform, increased 29%, to $86 billion. This growth rate is two percentage points higher than Q2 2015.

Active accounts expanded by 11%, to 188 million, during the quarter. Management cited its popular social-payments app Venmo as one of the factors behind new account growth.PayPal also succeeded in raising account activity during the second quarter, processing 1.4 billion transactions. The organization reported 29.4 transactions per active account, an improvement of 13% versus the prior year.

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PayPal appears to be benefiting from an "ease of use" push that includes promotion of its One Touch purchasing feature, as well as a mobile app redesign introduced earlier this year. Mobile payments leaped 56% over Q2 2015, and represented $24 billion in TPV, meaning that over a quarter of all PayPal's transactions in the second quarter were processed over mobile devices.

These metrics and their underlying trends translated to healthy financial results. PayPal's revenue advanced 15%, to $2.65 billion, and net income grew 10.4%, to $436 million. Operating margin, however, declined 330 basis points, to 14%. The company pointed to difficult comparisons with the prior year, due to the amendment of a co-branded credit-card agreement with Synchrony Financial, as well as the sale of a portion of its credit-receivables portfolio last year.

Operating margin has also been pressured as of late by higher transaction expenses, as PayPal processes more credit-card volume through its acquired Braintree subsidiary. While this volume is less profitable than debit card and ACH transactions, Braintree's services offer tangible long-term revenue growth potential, and executives have endorsed this trade-off for the time being.

On nearly every front, PayPal enjoyed a strong quarter, and management felt comfortable enough with forward prospects to raise full-year 2016 guidance. PayPal's revenue targets were moved from a range of between $10.5 billion-$10.7 billion to a new band of between $10.75 billion-$10.85 billion. Management also nudged the bottom of the range for expected full-year earnings per diluted share, from $1.09 to $1.11, while keeping the top-end of the range intact, at $1.14.

An agreement with Visa creates uncertainty

Credible earnings and a spruced-up outlook haven't lifted the PYPL ticker, however, as investors evaluate the implications of the company's new transaction partnership with Visa.Essentially, the agreement will promote Visa as a payment option within PayPal's platform, and Visa's digital-card images will be integrated into PayPal's payment flows.

PayPal has agreed not to encourage Visa customers to link up their bank accounts via ACH as a payment method -- ACH being a profitable payment method for PayPal, while a suboptimal choice for Visa. Finally, PayPal has agreed to cooperate with issuers to identify consumers who'd like to migrate existing ACH payment flows to their Visa cards.

In return, PayPal gets to join the Visa Digital Enablement Program, or VDEP, which will give PayPal's "digital wallet" product access to all retail locations that offer Visa's contactless payment system. This will quickly make PayPal a leader in near-field communication (NFC) payment. Finally, as part of the deal, PayPal will also receive economic incentives, "includingVisaincentives for increased volume, and greater long-termVisafee certainty."

Given the upcoming close level of integration with Visa, investors would like to understand how the agreement will effect both PayPal's transaction volume, and its take rate (that is, the percentage of money the company earns on its transaction volume). During the second-quarter-earnings conference call, CEO Dan Schulman answered an analyst's question on this topic by relating that any financial implications from the Visa deal for 2016 are already factored into current-year guidance. Further, Schulman suggested that more-specific projections related to the agreement would have to wait until year-end, as the company looks forward to 2017.

Visa's scale in the transaction-processing world presents concrete revenue opportunity for PayPal, but the uncertainty over the effect on transaction expense is proving a near-term damper on the company's shares. As we discussed above in relation to Braintree, PayPal executives don't mind temporarily depressing margin in order to increase market share.

The company also has many long-term margin-enhancing initiatives in the works, which could smooth out profit impacts from the Visa deal. Take the Venmo app, for instance, which is only at the very earliest stages of monetization. Venmo processed over $4 billion in person-to-person TPV during the quarter -- at a growth rate of 141%. Similar volumes running through merchants that Venmo signs up in the future could provide a palpable boost to operating margin.

In sum, calling a detente with Visa, which has been wary of PayPal's tremendous growth for some time, is a logical and strategic action for management to take. But it seems that shareholders will have to be patient for the next two quarters, until management relays the initial data, which will indicate how this transaction changes PayPal's business model going forward.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends PayPal Holdings and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.