Was PayPal's 7% Drop An Overreaction?

| About: PayPal Holdings, (PYPL)

Summary

PayPal was up 6% AH after announcing a deal with Visa but ended the day down 7%.

The deal with Visa means more expenses in the short term but greater opportunity in the long run.

The deal gives PayPal a leg up versus Apple Pay and Samsung Pay.

If PayPal can execute and keep growing the deal makes long term strategic sense.

On Thursday July 21st PayPal (NASDAQ:PYPL) released earnings for the quarter. The stock was initially up 6% after hours but ended Friday down by almost 7% with the volatility most likely due to differing opinions on the deal with Visa. So which stock reaction to the Visa (NYSE:V) news is the "correct" one, the 6% jump after hours or the 7% drop the next day?

PayPal gave out very little in the way of concrete details regarding the deal with Visa. Perhaps the best summary of the deal comes from the earnings conference call where PayPal CEO Dan Schulman said this:

Today PayPal and Visa announced a strategic partnership to further expand our longstanding relationship. This agreement will allow both companies to offer greater choice to merchants and consumers and increase value to Visa issuers and PayPal customers.

The benefits of this partnership include our ability to gain access to Visa's tokenization services, starting in the United States, for instore PayPal transactions. This will allow customers to pay with their Visa instruments and the PayPal wallet at the millions of retail locations where they see the Visa contactless logo. Importantly, retailers can expect to pay fees that are consistent with other contactless transactions they accept today.

We will provide greater accessibility for Visa payment instruments and the PayPal digital wallet. PayPal will also provide Visa, their issuers and their cardholders additional visibility into each Visa funded transaction, providing greater transparency and enhancing payment system security. The agreement affords PayPal certain economic incentives, including Visa incentives for increased volume and greater long-term Visa fee certainty and removes the threat of any targeted pricing actions.

On the surface the deal seems like good news. PayPal buries the hatchet with Visa and instead of having to worry about Visa as a potential competitor in the future, Paypal has Visa as an ally. Indeed, Visa's CEO Charlie Scharf had previously threatened to go after PayPal's core business. His famous line "I've been very, very clear on this one, which is if you are a foe, you're not a friend…" spoken at a JP Morgan Chase technology conference was a direct shot at PayPal.

There seem to be two issues worrying analysts. First, PayPal's management stated that the economics of the deal with Visa are already largely reflected in PayPal's guidance (to the degree that PayPal is able to forecast). Second, PayPal's CFO stated that the company will likely see increased transaction expenses as a result of a change in funding mix. This second reason is likely the biggest cause for concern out of the two.

In the past PayPal would strongly encourage users to link their PayPal account to a bank account and discourage the use of credit and debit cards. Using bank accounts allowed PayPal to process transactions via the much cheaper ACH network compared to Visa's (or any other issuers) more expensive payment processing network. Letting consumers link debit cards to PayPal and giving equal prominence to credit cards has analysts worried that PayPal's business model will crater as increased processing costs eat up profits.

Another part of the deal also allows PayPal to use Visa's tokenization service which allows PayPal to be used for NFC contactless payments via mobile devices. While NFC payment solutions are the hot new thing in the payments world we are a bit skeptical of how quickly they will be adopted. Checking out via a credit card just isn't a big pain point for consumers. Yes, NFC solutions are faster but saving a few extra seconds checking out doesn't make a big change when you are spending five minutes in a checkout line. Indeed, 72% of merchants still do not support an NFC payment option and of the 2M merchants that do allow NFC payments 400,000 of those are vending machines.

Summary

So what does all this mean for PayPal? Well the good news is that the deal with Visa allows PayPal to pretty much lock up the NFC market. With PayPal's huge user base it's going to be even more difficult for NFC solutions like Apple (NASDAQ:AAPL) Pay, Samsung Pay, etc. to break into the payments market. It also puts the 800lb gorilla in the room, Visa, back on PayPal's side and the threat of a Visa backed competitor is now removed. It's also likely the 800lb gorilla's brother (MasterCard (NYSE:MA)) and smaller cousin (American Express (NYSE:AXP)) may do deals with PayPal as well.

The downside for PayPal is the possibility that more users opt to use credit and debit cards and PayPal sees expenses rise. Conversely, the deal with Visa means increased payment volume and (likely) more user growth. It is basically now up to PayPal to execute their business and grow volume to make up more a possible increase in expenses.

Should PayPal stock have been up or down on the news? Well, it depends on whether you're a short term investor or a long term investor. Short term the stock reaction makes perfect sense. More expenses and possibly lower earnings in the near future should translate into the stock dropping. If you're a long term investor we think PayPal made a smart move. They collaborated with a potential competitor and they have the ability box out a few other upstarts (Apple and Samsung). The electronic payments space is a growing market and the more PayPal can cement its place in the core of that market the better. For the long run those are all positives for the stock and the price should have risen.

The fact that PayPal ended down 7% should tell you that there are simply more short term oriented market participants then there are long term ones. If your long term oriented we think PayPal still makes a good investment (we have owned and still own it). If your short term oriented the unknown of higher expenses could mean some missed earnings in the next few quarters and PayPal stock might not be a great buy.

Disclosure: I am/we are long PYPL, V.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.