3 Long-Term Benefits of PayPal's Credit Card Partnerships

PayPal (NASDAQ: PYPL) began striking partnership agreements with credit card payment networks and issuers in 2016. It started with Visa, and it quickly expanded to Mastercard, Discover Financial, JPMorganChase, Citigroup, and more.

The crux of the deals was PayPal would stop promoting payments from users' bank accounts or existing balances over using a debit or credit card. In exchange, PayPal would get a discount on processing fees and access to their tokenization systems that enable contactless payments in stores.

Investors weren't too happy with those terms, as PayPal keeps a much higher percentage of payments made directly from bank accounts versus those made with credit cards. But PayPal has seen more benefits from the deals than just saving a few basis points on its credit card processing fees.

A simpler sign-up process

About two years ago, PayPal was losing around 1 million customers per month, according to CEO Dan Schulman, because its onboarding process for new customers was too onerous. Users would give PayPal a debit or credit card, and PayPal would also ask for a bank account and try to get them to sign up for PayPal Credit.

The agreements with the credit card companies prevent PayPal from encouraging users to link their bank account that way. As a result, PayPal's sign up process is dramatically simplified.

And it's paid off in an acceleration of net new active customers, which increased 61% in the fourth quarter to 8.7 million. Total active customers increased 29 million, or 15%, in 2017 compared to 18 million, or 10%, in 2016.

Partners promoting PayPal

One of the key features of PayPal's agreements with credit card companies is that customers could set their default payment to a credit card. And with PayPal transacting hundreds of billions in payment volume per year, credit card companies all want to control that default payment option in customers' PayPal accounts.

As such, many credit card issuers started incentivizing their customers to add their credit card to PayPal. Credit card companies also started enabling customers to redeem their reward points through PayPal, as a way to incentivize continued use of PayPal (and their default credit card).

As mobile commerce (both online and in store) continues to grow, credit card issuers may find it more efficient to get their customers to link their cards in PayPal than to get them to download yet another app just to use their credit card. Even then, PayPal has a much higher conversion rate on mobile -- 87% -- compared to the industry average of 44%. So it's in issuers' best interest to get their customers to use PayPal.

Increasing engagement

Another big benefit has been an increase in engagement among PayPal users. As PayPal opened up more default payment options, it also saw an increase in the number of transactions on its platform.

The new users PayPal is bringing on board are using the platform more frequently than the customers it has had longer. Overall, transactions per account increased 8% in 2017, which is actually a slowdown from the 13% growth PayPal saw in 2016. That said, Schulman expects the acceleration in user growth will start to show up with a reacceleration in transactions per customer as the trends play out.

Long term, Schulman believes PayPal can reach one to two transactions per week per customer. It currently averages less than one transaction every 10 days -- 33.6 per year. So there's a lot of room to grow.

The impact on take rate

The biggest concern over the deals with credit card companies is that PayPal's take rate -- the percentage of payment volume it keeps as net revenue -- would fall sharply as more users opt for credit cards.

While PayPal's take rate declined 15 basis points to 2.53% in 2017, PayPal says that's largely a result of an increase in peer-to-peer payments, driven by the continued growth of Venmo. PayPal doesn't take a cut of most peer-to-peer payments. It's worth noting that PayPal's take rate was declining well before PayPal struck deals with credit card companies, and the decrease in 2017 is consistent with previous years. So, overall, there was minimal impact on PayPal's profit margin.

PayPal has gotten a lot of benefits from the partnerships, and at practically no cost. It has yet to really tap the ability to offer secure in-store payments, but Schulman says that's coming. Investors may have been displeased with the partnership agreements at first, but taking a long-term view has paid off for PayPal.

10 stocks we like better than PayPal HoldingsWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and PayPal Holdings wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of March 5, 2018

Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Mastercard, PayPal Holdings, and Visa. The Motley Fool has a disclosure policy.