PayPal Is Powering Growth by Focusing on the Small Things

By John Ballard Markets Fool.com

Image source: PayPal Holdings, Inc.

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PayPal Holdings (NASDAQ: PYPL) is a simple business to understand. In the last two quarterly earnings reports, after highlighting results for revenue and earnings per share, PayPal began discussing two financial metrics that drive everything management does to grow the value of the business for shareholders:

  1. Active customer accounts
  2. Transactions per active account

PayPal's strategy is clear and management is completely focused on driving growth in these two metrics. When we multiply the growth in customer accounts with the growth in transactions per account, we get a result that is almost equal to the growth in total transactions processed.

In each of the last two quarters, active customer accounts grew 11%, and transactions per account grew 13%. Multiplying these growth rates together gives a 25% growth rate, which is nearly identical to the growth in total transactions processed over the last two quarters. Total transactions processed drives growth in total payment volume (TPV), which grew 28% to $87 billion on a currency-neutral basis in the third quarter of 2016.

PayPal generates revenue by a transaction fee -- usually 2.9% -- on every transaction made on its payments platform. After paying transaction expenses and costs, PayPal is left with a transaction margin of 58.7%, as of the 2016 third quarter. This means PayPal is left with $0.587 for every dollar of revenue to cover other operating expenses like customer support, marketing, and product development.

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Ultimately, PayPal wants to grow free cash flow. After all, the value of every business is determined by the present value of its future free cash flows. Management does a good job of controlling operating costs, so free cash flow will take care of itself as long as management executes its strategy.

PayPal's strategy is directed toward driving higher customer adoption, measured by active customer account growth, and increasing customer engagement, measured by transactions per account.

So, how exactly is PayPal increasing customer adoption and engagement?

Partnerships extend PayPal's reach to more customers

Since PayPal was spun off fromeBayover a year ago,partnering with banks and credit card issuers, such as Visa (NYSE: V), Mastercard (NYSE: MA), and Citigroup (NYSE: C), has become a core part of PayPal's strategy.These partnerships go a long way toward increasing customer adoption and engagement because of the number of locations that will accept PayPal. Offering customers more choices and expanding the number of ways customers can use their PayPal accounts is a good way to attract more customers and drive higher frequency of use per customer.

Small features increase engagement

Partnerships are crucial to PayPal's strategy, but equally important is the steady stream of new features and add-on services PayPal introduces to encourage customers to use PayPal more frequently, as well as making it easier and more convenient for customers to send money.

For example, Apple'snew iOS 10 software upgrade for iPhone allows Venmo users to use Siri to send and request money. Venmo is a peer-to-peer (P2P) payments app owned by PayPal that is very popular among millennials.

Also, PayPal has launched new capabilities to Xoom -- its international payments transfer business -- to allow users to link their PayPal and Xoom accounts. This immediately added 10 new countries users can send money to, bringing the total number of accessible markets for PayPal and Xoom users to over 200 worldwide.

PayPal also allows Xoom users who live outside of the United States to send a "request" for a money transfer to friends and family in the United States. This is a revolutionary new feature that gives receivers more control and choice over the process of international money transfers, something traditional money transfer services didn't offer in the past. This is one small example of how Xoom is disrupting the $600 billion cross-border money transfer market.

In early December, PayPal launched a new feature to allow customers to send money as a gift for the holidays in the form of stylized digital holiday cards. It doesn't seem like much, but investors are eager to find out whether there were a few more PayPal users who engaged with their PayPal accounts and sent digital holiday cards in December. This is one among many new enhancements PayPal is working on to improve the user experience, and therefore drive higher engagement.

The results of these enhancements to the user experience is clearly seen in the acceleration of transactions per active customer account over the last few years.

Year

Growth in Transactions Per Account

2014 7%
2015 12%
First nine months of 2016 13%

Data source: PayPal Holdings 10-K and 10-Q SEC filing.

PayPal processed $87 billion in TPV and 1.5 billion total transactions in the third quarter. That works out to an average $58 processed per transaction. The difference between growing transactions per account at 7% as they did in 2014, compared to the 13% in the first nine months of 2016, is the difference of about $5.8 billion in additional TPV per quarter, or an annual run rate of about $23 billion. The additional $5.8 billion in quarterly TPV translates to over $500 million in annual revenue, or about 5% of expected full-year 2016 revenue.

Each new announcement doesn't seem like much, but add all of these new features together, and it builds PayPal's momentum in customer account growth and transactions per account, which directly impacts growth in TPV and revenue.

Building a brand

PayPal needs a durable competitive advantage to sustain growth over many years to be a good investment. Beyondhelping PayPal drive growth in the short term, new enhancements and partnerships are increasing PayPal's ubiquity. The more ubiquitous PayPal becomes, the more customers become aware of the PayPal brand.

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John Ballard owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends Apple, eBay, Mastercard, PayPal Holdings, and Visa. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.