What to Watch at PayPal in 2017

By John Ballard Markets Fool.com

PayPal Holdings'(NASDAQ: PYPL) stock has lagged the S&P 500 Index since the election, but depending on how certain things develop in the new year, shareholders may see PayPal outperform the broader market.

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Investors are waiting for continued signs of strength in PayPal's payments platform to catapult the stock out of its recent rut. Key metrics to watch are active customer accounts, transactions per active account, and growth in revenue of at least 15% year over year. Revenue is directly impacted by growth in transaction payment volume (TPV). PayPal has enjoyed strong gains of more than 25% year over year in TPV during 2016 thanks to double-digit growth in active customer accounts and transactions per active account.

Image source: PayPal Holdings, Inc.

Innovation

In order to keep this momentum going, PayPal needs to keep growing transactions per active customer account, which is correlated with new enhancements to PayPal's payments platform. If growth in either customer accounts or transactions per account suddenly decelerates to single-digit rates, it could be a sign that competitors are taking potential customers away from PayPal.

One threat in particular facing PayPal next year is ClearXchange, a peer-to-peer (P2P) payment system set up by major banks that allows people and businesses to send money to anyone with a U.S. bank account. The money is directly deposited into the recipient's bank account. It's the major banks' answer to PayPal's own P2P service, Venmo. However, the continued growth in Venmo's TPV, which grew over 100% in the recent quarter, indicates the current strength of Venmo's brand.

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The steady stream of new features has been the recipe for increasing PayPal's transactions per account. The successful One Touchfeature -- which enables users to use PayPal at online checkouts without entering their login information -- and the integration of Apple'sSiri -- which allows PayPal users to send and request money by voice command on Apple devices running iOS 10 --are good examples of recent innovative features that the company needs to continue building its brand and growing its business. The integration with Apple's Siri underlines the importance of PayPal's partnerships to drive growth.

Partnerships and acquisitions

Partnerships play a crucial role in extending PayPal's reach to new customers and driving higher engagement. The deal with Visa(NYSE: V) opened the door for partnerships with Mastercard(NYSE: MA), Citigroup(NYSE: C), and Fidelity National Information Services (NYSE: FIS). As a result, more deals will come that will increase PayPal's relevancy and ubiquity in the mobile payment landscape.

In addition to partnerships, PayPal could make another acquisition, especially considering the $6.4 billion in cash on the balance sheet.After all, "Holdings" is in PayPal's title for a reason. It certainly has enough cash on hand and cash-generating ability to make at least a small acquisition that could enhance its mobile payments technology.

Cost controls

The ability to make acquisitions places emphasis on PayPal's ability to generate cash from its operations. Growth in free cash flow (cash from operations minus capital expenditures) in proportion to revenue will tell us how well management is controlling costs and managing losses related to PayPal's credit and loan business.

From 2013 through 2015, growth in loss provisions related to PayPal's credit and loan businesses cut about 1% per year out of free cash flow margin -- free cash flow divided by total revenue. Free cash flow margin was over 23% in 2013, and by 2015, it was below 20%.

In the past, PayPal has financed consumer credit and loans with its own cash flow. Management's goal is to lessen the burden on PayPal's cash and, instead, use external financing. For example, in Q1 2016, PayPal began using $800 million of European customer balances to fund credit to European customers. Furthermore, the company recently struck a deal with Latitude Financial Services to fund credit to Australian customers.These efforts should free up PayPal's cash flow for higher return initiatives. So far in 2016, free cash flow margin is back to almost 22% in the first nine months of the year.

On another front, the recent acquisition of Xoom has been a drag on PayPal's margin in 2016. Excluding Xoom, PayPal's operating expense has increased less than 10% in each of the last three quarters compared to revenue growth ranging from 15% to 19%. This means, excluding Xoom, more of PayPal's revenue is flowing down to net income, or earnings.If management can control Xoom's expenses better in 2017, PayPal's operating margin would increase, and, therefore, earnings growth would benefit.

Four things to watch

As we move through 2017, signs of strength in PayPal's margins, steady growth in PayPal's key metrics -- active customer accounts, transactions per account, revenue, and free cash flow --more innovative features, and partnerships would all be great signs for shareholders.

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John Ballard owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends Apple, 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.