Paypal Holdings, Inc. quarterly report, Q2 FY2017

PayPal Holdings, Inc. — Q2 2017 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2017; filed July 27, 2017. PayPal operates a global digital payments platform, including PayPal, PayPal Credit, Braintree, Venmo and Xoom. Amounts below are U.S. dollars.

Financial results and key metrics

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Net revenue	$3.136bn	$2.650bn	$6.111bn	$5.194bn
Operating income	$430m	$371m	$861m	$778m
Operating margin	14%	14%	14%	15%
Net income	$411m	$323m	$795m	$688m
Diluted EPS	$0.34	$0.27	$0.65	$0.56
Cash provided by operations	$921m	$696m	$1.672bn	$1.434bn
Free cash flow (non-GAAP)	$747m	$495m	$1.350bn	$1.100bn

• Q2 revenue rose 18%, while operating income rose 16% and net income rose 27%. Six-month revenue rose 18%, operating income 11%, and net income 16%.
• Q2 Total Payment Volume (TPV) was $106.4bn, up 23%; payment transactions increased 23% to 1.775bn, and active customer accounts rose 12% to 210m. Transaction revenue grew more slowly than TPV, partly because of increased lower-rate person-to-person activity and large-merchant volume.
• Operating expenses increased 19% in both the quarter and first half. Transaction expense increased 31% in each period; management cited higher processor assessments and unfavorable funding mix. Transaction and loan losses increased 21% in Q2 and 19% in the first half.
• Cash and cash equivalents were $1.271bn at June 30, versus $1.590bn at year-end 2016. Cash, cash equivalents and available-for-sale investments totaled $6.446bn, excluding customer-account assets and restricted cash. Customer funds receivable and accounts were $16.178bn, with corresponding funds payable and amounts due to customers of $16.978bn.
• No borrowings or letters of credit were outstanding under the $2.0bn revolving credit facility; the full capacity was available, subject to customary conditions. The filing does not provide a clear separate total for conventional debt in the financial statements presented.

Material changes and notable items

• Consumer and merchant loans and interest receivable reached $6.1bn, up 28% year over year. Consumer loans and interest receivable were $5.5bn; merchant Working Capital advances and fees receivable were $633m. Six-month loan losses were $252m, up 29%; consumer net charge-off rate was 6.9%, compared with 6.3% a year earlier.
• Six-month operating margin declined to 14% from 15%. Management attributed the decline to transaction expense and transaction and loan losses growing faster than revenue, plus $40m of restructuring expense; operating efficiencies partly offset these pressures.
• Cash used in investing activities was $3.002bn in the first half, primarily reflecting investment purchases and $627m of net growth in principal loans receivable. Financing activities provided $988m, including a $1.638bn increase in customer funds payable, partly offset by $606m of share repurchases.
• PayPal repurchased $606m of shares in the first half under its existing program. A new $5bn authorization becomes effective after the earlier $2bn program is completed; $399m remained under the earlier authorization at June 30.
• In July 2017, after quarter-end, PayPal completed its approximately $238m cash acquisition of TIO Networks to expand bill-payment capabilities.

Outlook, commentary, risks and contingencies

• The filing provides no quantified forward financial guidance. Management said available cash, investments, operating cash generation and expected capital-market access should be sufficient for operating activities, anticipated capital expenditures and credit products for the foreseeable future.
• Management expects the workforce-reduction plan, with approximately $40m total cost, to be substantially completed by year-end 2017; anticipated expense savings are expected to be reinvested in the business.
• Key risks include changing payments regulation, consumer-protection and privacy requirements, fraud and transaction losses, credit performance, dependence on partner banks for U.S. lending, foreign-exchange movements, and Brexit-related uncertainty. The company reported 46% of Q2 revenue from customers outside the U.S.; U.K. revenue represented 11%.
• Regulatory matters include an FTC investigation concerning Venmo, OFAC inquiries into self-reported possible sanctions violations, and DOJ subpoenas concerning the historical anti-money-laundering program. The securities class action related to Venmo disclosures was voluntarily dismissed without prejudice; related shareholder derivative cases remained pending. Management said accrued legal and regulatory amounts were not material, but outcomes and possible non-monetary remedies remain uncertain.
• The estimated maximum potential exposure under buyer and seller protection programs was $139.5bn; this is not management’s estimate of expected losses. The recorded transaction-loss allowance was $223m. The company stated it had no material off-balance-sheet arrangements.
• The effective tax rate was 8% for Q2 and 10% for the first half, below prior-year rates of 15% and 14%, respectively. Management cited accounting changes affecting stock-based compensation tax benefits and intra-entity asset transfers. Q2 comprehensive income was $311m, including a $100m net other comprehensive loss, primarily reflecting hedge-related changes.

Important facts for investors to verify

• Whether revenue growth and TPV growth can continue while transaction monetization is affected by lower-rate P2P and large-merchant mix.
• Whether higher processing costs and growth in credit receivables and loan losses will continue to pressure margins and cash needs.
• Credit portfolio performance, including delinquency, charge-off and allowance trends for consumer loans and merchant advances.
• Developments and potential financial or operating effects from FTC, OFAC, DOJ and shareholder derivative matters, as well as evolving regulatory requirements.
• Use of capital for share repurchases, credit funding and the TIO acquisition, and the impact of foreign-held cash and currency movements.