PayPal Has a Winning Strategy

Image source: PayPal.

PayPal (NASDAQ: PYPL) is making some important alliances. After partnering with with leading card operators Visa (NYSE: V) and MasterCard (NYSE: MA) in recent months, the company has announced a new partnership with Facebook (NASDAQ: FB). These partnerships will probably hurt profit margins on transactions over the short term, but PayPal is doing the right thing by prioritizing its long-term growth opportunities over current earnings.

PayPal is making new friends

PayPal has always had a mixed relationship with Visa and MasterCard. The digital-payments leader and the credit card companies are partners and competitors at the same time. Credit card operators charge substantial processing fees on payment transactions, so PayPal used to encourage its customers to link their PayPal accounts directly to their bank accounts via ACH as opposed to credit cards, to avoid paying those fees.

However, this will no longer be the case going forward. The complete financial details of the new agreements between PayPal and card operators have not been disclosed, but PayPal has promised to make it as easy as possible for customers to choose either bank accounts or Visa and MasterCard accounts. This approach will clearly benefit card companies with higher processing fees, while PayPal will now be more easily accessible in mobile wallets using Visa or MasterCard networks.

More recently, PayPal and Facebook have broadened their partnership, making it easier for PayPal customers to link their PayPal accounts to Facebook and Messenger, while also rolling out PayPal as a payment option for a broad range of shopping features through Facebook. Among other features, items purchased by interacting with chatbots from online merchants through Messenger can now be paid with PayPal. In a previous deal, PayPal's Braintree partnered with Facebook and Uber in December 2015, allowing users to pay for Uber trips via Messenger.

The market reacted with negativity to the announcement. PayPal stock declined 2% when the company reported the enhanced partnership with Facebook, probably because most investors assume that PayPal will make smaller profit margins on transactions made through Facebook and Messenger, which is arguably a reasonable assumption.

On the other hand, the agreement offers exciting growth opportunities for PayPal. Facebook had 1.71 billion monthly active users as of the second quarter of 2016, growing 15% year over year. On mobile devices, Facebook reaches 1.57 billion monthly users, a 20% annual increase during the second quarter. Messenger has over 1 billion active accounts, and it's the leading over-the-top mobile messaging app in the United States. According to data from eMarketer, nearly 37% of mobile users in the country have a Messenger account.

There is a common theme in the recent alliances that PayPal is forming with companies such as Visa, MasterCard, and Facebook. The digital-payments leader is partnering with tremendously powerful brands, and these partnerships offer plenty of opportunities for revenue growth, but the company is paying the cost of such alliances by generating reduced profits on every transaction.

PayPal is doing the smart thing

The most visionary growth companies are the ones willing to make serious efforts in the present to capitalize on growth opportunities over the long term. PayPal management calculates that the company's total addressable market is worth nearly $100 trillion, so capturing a big share of such massive opportunity should be a priority for PayPal over current margins on transactions.

Even if the company will make smaller margins on every transaction, that doesn't necessarily mean overall profit margins are going to decline. PayPal's operating costs are relatively fixed in comparison with sales. All else being the same, operating profit margins should expand as revenue increases, since a big share of such costs should increase at a slower speed than revenue.

The company recently reported earnings for the third quarter of 2016, and management provided a fairly optimistic guidance for the coming years. PayPal increased its guidance for revenue growth from 15% in constant currency terms to 16%-17% per year. Importantly, the company expects non-GAAP operating margin to remain "stable to growing" over this period. Healthy margins guidance is probably reflecting that the positive impact from growing revenue is expected to more than compensate for declining margins on every transaction because of the recent alliances PayPal has formed.

By partnering with names such as Visa, MasterCard, and Facebook, PayPal is reducing competitive risk and positioning itself for massive expansion over the years and even decades ahead. It looks as if overall profitability will remain healthy going forward, so PayPal is making a smart move when considering both the benefits and costs of such partnerships from a long-term perspective.

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Andrs Cardenal owns shares of MasterCard. The Motley Fool owns shares of and recommends Facebook, MasterCard, 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.