How PayPal Is Defying Expectations and Boosting Its Bottom Line

When PayPal (NASDAQ: PYPL) first announced partnerships with Visa and Mastercard in 2016, investors were concerned about their impact on the bottom line. A higher volume of credit card payments would cause PayPal to incur higher fees paid to credit card companies.

This has played out as expected with transaction expense -- PayPal's largest operating expense -- increasing 550 basis points to 33.7% of revenue since 2015. That is a lot, which, if not offset by a reduction in other expense items, would have caused PayPal's operating profit to be only $1.3 billion in 2017 -- about 37% less than what it actually reported last year.

Of course, that didn't happen. PayPal's earnings have been growing faster than revenue, and it's because of an interesting trend taking shape. PayPal's "more choice" strategy is leading to a more user-friendly service that is allowing PayPal to spend less on things like customer support. This has allowed PayPal to actually expand its operating margin, and management expects this trend to continue.

More choice is helping PayPal expand margins

Customer support is PayPal's second largest expenditure after transaction expense. As PayPal has offered users more payment options, management has had fewer calls coming into call centers. This also reflects investments PayPal has made to make its payment platform easier to use. Spending on customer support made up 13.2% of revenue in 2015, but as of the first quarter of 2018, it's down to 9.5%.

Essentially, management has offset most of the 5.5% increase in transaction expense with a 3.7% reduction in customer support as a percentage of revenue. In total, all expenses not related to transactions -- including product development, among other things -- have been growing much slower than revenue recently. This has caused non-transaction-related expense to decline from 40% of revenue to 31% over the last two years, and that has offset all the increase in fees PayPal was charged by financial institutions every time users paid with a credit card out of their digital wallets. The net effect has been a 2.5% expansion in PayPal's non-GAAP operating margin. It reached an all-time high of 22.5% in the first quarter.

Typically, it would be easy to think management is underfunding its long-term growth by letting investments in things like product development slide, but CFO John Rainey doesn't see it that way. On the first-quarter conference call, he said, "We believe that we can sustainably grow our business with this level of investment in our non-transactional-related expenses, allowing us to continue to deliver operating margin expansion."

In 2017, PayPal saw its customer account growth accelerate to 15% from 10% the year before. Those customers are using their accounts more frequently, and that culminated in a blowout first quarter for the mobile payment provider. Revenue grew 22% on a currency-neutral basis, while non-GAAP earnings per share surged 29% year over year. Clearly, PayPal wouldn't be able to deliver those kinds of numbers if it were not investing in areas to facilitate that level of growth.

Looking ahead, management has guided for 2018 revenue growth between 15% and 16%, with non-GAAP EPS growth of 21.5% at the low end of guidance. Higher growth in earnings reflects continued modest expansion in non-GAAP operating margin.

Management is executing its strategy extremely well

The partnership strategy was designed to accelerate PayPal's momentum on the top line, but it was equally balanced with a focus on bottom line growth as well.

One other catalyst investors should be aware of is that PayPal is beginning to roll out new monetization features for its popular Venmo peer-to-peer payment app, which is quickly approaching 10% of PayPal's total payment volume. This will add some profit contribution going forward and provide an additional driver for PayPal's margin improvement and overall profitability.

The key takeaway from all of this is that management has several levers to keep PayPal's momentum going strong, especially on the bottom line, while not sacrificing its competitive position for the long term. PayPal's stock currently trades for a forward P/E of 27x based on 2018 guidance, which is not cheap. But with margins expanding, Venmo's contribution to profitability coming along, as well as the opportunity to capitalize on the fast-growing $2.3 trillion e-commerce market, the stock still might be worth paying up for.

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 quadrupled 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 May 8, 2018

John Ballard owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends Mastercard, PayPal Holdings, and Visa. The Motley Fool has a disclosure policy.