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Two of the biggest players in the payments industry today are Visa (NYSE: V) and PayPal Holdings (NASDAQ: PYPL). Each company has a major stake in the future of payments, and each has the potential to provide strong returns for shareholders in the coming years.
Looking at the payments landscape today, an investor may question which of these two household names represents the better buy. Let's find out.
Comparing and contrasting PayPal and Visa's business models
Both Visa and PayPal are payment companies, but they are each a little different in exactly how they go about making money in this space.
Visa is a pure payment processor. The company owns and maintains the digital infrastructure that facilitates payments between customers, banks, and merchants anytime a Visa-branded card is swiped or used.
Visa doesn't make loans, accept deposits, or operate as a gateway for merchants and consumers. In oversimplified terms, the company is just a middleman, almost like a toll collector on a highway. As the transactions move down Visa's highway, the company collects a small fee before allowing the payment to process.
While Visa is exclusively focused on payment processing, PayPal does a lot of different things within the payments niche. It processes payments between its users. It's a gateway that can connect consumers or merchants to other payment processors, like Visa's. It's a platform for e-commerce with a full suite of tools to help websites and digital businesses monetize. It even provides a limited suite of traditional banking products like merchant services, working capital loans, and deposit products.
In this way, Visa and PayPal compete with each other to some degree, but more often they co-exist with complementary services.
During the quarter ending June 30, the two companies announced a new strategic partnership that brings them even closer together. The deal strengthens Visa's relationship with a major online, e-commerce gateway, and it gives PayPal protection from fee hikes or potential throttling of transactions on Visa's payment processing network.
The market did not view the agreement as the win-win situation, however. PayPal shares actually fell sharply on the announcement. The market had hoped that PayPal could grow to one day compete directly with Visa and tap into the multi-trillion dollar global payment processing business at scale. By agreeing to partner, some viewed PayPal as conceding to Visa, rather than taking on the challenge.
Comparing each company's financial results and valuation
Both Visa and PayPal put up strong numbers in the quarter ending June 30, continuing trends that have driven both company's valuations to above 30 times their trailing-12-month earnings.
For PayPal, the second quarter was all about growth. Adjusted for currency fluctuations, revenue grew 19% year-over-year. Earnings per share jumped 7%. Customer accounts increased 11% and payment transactions leapt 25%. The company generated almost $500 million in free cash flow in the quarter on revenue of just $2.65 billion.
Visa's quarter, while not as red hot as PayPal's, was still impressive in its own right. Payments volume grew 10% as of June 30, with the number of transactions also increasing 10% year-over-year. Revenue was up 6%, while earnings per share declined 4% on a constant dollar basis. The EPS drop is a bit misleading, however, skewed by a $280 million tax benefit in last year's fiscal third quarter.
On a trailing-12-month basis, Visa's returns on equity are nearly double that of PayPal's, at 19.3% versus 10.1%, respectively.
Both companies trade at high price-to-earnings ratios, although those multiples are driven by slightly different reasons. Visa's valuation should be seen as a reflection of both healthy growth and strong returns, while PayPal's is driven more by growth potential than by profitability.
Venmo -- PayPal's wild card
The rising star in PayPal's business is its peer-to-peer payments product, Venmo.
Venmo is wildly popular with the millennial generation, allowing two individuals to swap money with just their mobile phones, for free. In the first quarter, payment volume on Venmo grew 154% year over year.
Currently, Venmo doesn't charge customers for payment transfers using their debit card or directly from their bank account. There is a small fee for payments from credit cards. That means that PayPal is actually losing money on the vast majority of Venmo transactions, as banks and payment processors still charge interchange fees on every transaction. Thus far, PayPal has been content to take those losses in exchange for the app's incredible growth.
Going forward, the plan is to monetize Venmo by allowing customers to pay for their goods and services directly through the Venmo app with a new feature called "Pay With Venmo." This service, now being deployed at retailers online and in physical locations, hopes to monetize the Venmo user base without charging users directly.
The payments industry is a $100 trillion market. If Pay With Venmo succeeds in gaining even a few basis points of market share, the financial windfall for PayPal could be enormous.
It should be noted that payment processors like Visa still get a cut whenever a Venmo user chooses to use their Visa-branded card for a Venmo transaction. In the past, a consumer may have swiped a Visa-branded card at checkout, but in the future that person may use Venmo to effectively do the same thing. In this way, Visa won't necessarily suffer from the rise of Venmo, but it won't necessarily benefit, either. PayPal, on the other hand, will clearly benefit from this new revenue stream.
To me, both Visa and PayPal are excellent companies with strong financials and very bright futures. Both trade at premium valuations, reflections of their strength today and also their potential in the future. And while I think both stocks have the potential to do well for investors, it's my view that the untapped potential of Venmo makes PayPal Holdings the better buy today.
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Jay Jenkins 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.