Why PayPal Holdings Wants Out of (and Synchrony Financial Wants In) the Credit Game

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Last month, PayPal Holdings Inc (NASDAQ: PYPL) announced it would be selling its U.S. consumer credit portfolio to Synchrony Financial (NYSE: SYF). Under the terms of the deal, Synchrony Financial receives $6.8 billion in receivables and PayPal receives the portfolio's "approximately par" value in cash from Synchrony. As part of the agreement, Synchrony will also become the exclusive issuer of PayPal's U.S. consumer credit financing for the next 10 years. PayPal will share in the revenue generated from credit to help offset the lost revenue from the interest it charged on its loans.

Under terms of the deal, PayPal and Synchrony will share data, leading to what the two companies believe will be "superior" fraud and risk management. PayPal will retain control over marketing, customer acquisition, and the checkout experience, while Synchrony will handle the authorization and processing of the all transactions and legal compliance matters.

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Shares of both companies jumped on the news. For PayPal, it removes the vast majority of credit risk from the business, generally meaning that Wall Street will be more likely to assign it a higher valuation. The concern about credit risk isn't without some merit: This past quarter PayPal's net charge-off rate was 6.4%. For Synchrony, the deal plays directly to the company's strengths by offering consumer credit through third-party platforms.

Why PayPal even offers credit

PayPal has telegraphed its desire to move to an asset-light business model almost since it was spun off from eBay in July 2015. During the conference call held after the announcement, PayPal management revealed they had been working on the deal for a better part of the year. This was no surprise, as PayPal had made it clear it was more than willing to move its credit portfolio if the terms of the arrangement were right.

For instance, in its 2016 fourth-quarter conference call, CEO Dan Schulman said, "[W]e are assessing a more asset-light strategy to our credit business. While it's too early to provide additional detail, moving more of our credit receivables off balance sheet and potentially further partnering on the origination side can free up cash and give us additional flexibility."

With the credit risks involved, one might wonder why PayPal ever offered credit to its account holders in the first place, but in reality, credit is a crucial piece to the puzzle for PayPal. Without an option for credit, PayPal could never be a holistic payment platform for its customers. Schulman has explained this concept several times, but perhaps best elucidated it during last year's fourth-quarter conference call:

What PayPal gets out of the deal

The deal essentially allows PayPal to have its cake and eat it, too. There are several significant aspects of the agreement that should be duly noted by investors. First, and most importantly, PayPal does not lose a crucial part of its payment ecosystem. PayPal will still be able to offer credit to its customers when they log into their account or during the checkout process of an online retailer. While PayPal will no longer receive revenue from interest it charged on its loans, the deal does contain "attractive profit share economics," according to the company.

Second, PayPal's credit platform was a small part of its overall business, accounting for approximately 2% of its total payment volume. But, because issuing credit is so capital intensive, it effectively tied up 40%-50% of the company's free cash flow. The deal allows PayPal to now pursue higher returns with that cash. The three possibilities PayPal discussed in the call following the announcement was investing the money back in the core business (enabling faster development of new product features), returning more money to shareholders (presumably through share repurchases), and pursuing acquisitions.

One final note: The money PayPal received from Synchrony for its current credit receivables will be held in a foreign account. So, depending on pending tax reform, PayPal might issue more debt to return money to shareholders or make an acquisition.

What Synchrony gets out of the deal

Synchrony is one of the largest domestic providers of private-label credit cards, commonly referred to as store credit cards. Its customers include a number of brick-and-mortar retailers like Wal-Mart Stores, TJX Companies Inc's retailers including TJ Maxx and Marshall's, and Lowe's Companies. While brick-and-mortar retail is in danger of losing ground to e-commerce, Synchrony is also the issuer for Amazon.com's Prime card. With this deal, Synchrony virtually secures itself as the top dog in the credit-issuing business for online third-party payment platforms and retailers.

Synchrony's strong balance sheet and extensive product suite also means it will be able to serve these loans at a lower cost than PayPal. In Synchrony's third-quarter earnings release, the company reported $76.9 billion in loan receivables. Acquiring PayPal's $6.8 billion portfolio grows Synchrony loan receivable business by almost 9% overnight.

Everybody's a winner

At the end of the day, the deal appears to be a win for both companies as it allows each to do what it does best. PayPal can continue serving as a holistic and device-agnostic payment platform. Due to the profit-sharing agreement, it will continue to benefit from offering credit to its customers while not keeping half of its free cash flow from higher-margin opportunities. Synchrony's balance sheet and core competency will allow it to serve these loans at a lower cost, and it gives the company a chance to profitably grow away from an overreliance on traditional retailers.

In fact, while I am a longtime shareholder of PayPal, I will use this opportunity to give Synchrony Financial a green thumbs-up (outperform) on my CAPS page.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Cochrane owns shares of Amazon and PayPal Holdings. The Motley Fool owns shares of and recommends Amazon, eBay, and PayPal Holdings. The Motley Fool recommends Lowe's, Synchrony Financial, and The TJX Companies. The Motley Fool has a disclosure policy.