Among the first things I look for in potential investments are whether they operate in a growing market and if they have what appear to be sustainable competitive advantages. That's why two of my largest personal holdings are Mastercard(NYSE: MA) and PayPal (NASDAQ: PYPL).
As the world moves toward e-commerce and mobile payments, Mastercard and PayPal are both well positioned to take advantage of consumers' changing behavior and are benefiting from a growing network effect moat. But which makes for a better investment today? Let's take a closer look at each to see if we can reach a satisfactory answer.
A man shops online using a tablet while holding a credit card.
Both PayPal and Mastercard are riding rising trends, such as e-commerce and mobile payments, to great returns. Image source: Getty Images.
The case for PayPal
PayPal is also developing a network effect moat of sorts. In its last quarter, the company reported 254 million active accounts, a 15% increase year over year. Of course, the more users who have PayPal, the more likely that merchants will be compelled to accept PayPal as a payment method, both online and in-store. The more merchants accept PayPal, the more consumers will want to open an account and the more opportunities they will have to use their account. This has proven to be the case, and in the third quarter, transactions per active account over the trailing 12 months -- an important user engagement metric -- rose to 36.5, a 9.5% increase year over year.
One of the most important factors in driving this customer engagement has been customer choice. Since spinning off from eBay in 2015, PayPal has entered a number of partnerships and agreements with different banks, credit card networks, and merchants, giving account holders more ways than ever to use their accounts. This includes things such as choosing different cards to pay for different types of purchases and giving consumers more places than ever before to use their PayPal accounts.
In the company's 2018 third-quarter conference call, CEO Dan Schulman said:
Customer choice also continues to yield a meaningful lift in our engagement metrics. Today, nearly all of our customers have choice available to them, and more than 55 million PayPal customers have actively used choice in some 200 markets. Another very important outcome of choice was that it enabled PayPal to develop deep partnerships throughout our ecosystem. In just over two years, we've signed over 35 partnerships with some of the world's largest and most influential brands in finance, technology, and commerce.
This quarter, PayPal announced a major partnership with American Express(NYSE: AXP). Among other things, the deal will integrate PayPal's and Venmo's P2P capabilities with mutual account holders and allow account holders to use their Amex reward points to make purchases at merchants accepting PayPal.
The account and user engagement growth continue to drive PayPal's top and bottom lines. In Q3, revenue grew to $3.68 billion, a 14% boost year over year, and adjusted EPS rose to $0.58, a 26% jump year over year. PayPal currently sports a P/E ratio of about 38.
The case for Mastercard
Mastercard acts as a payments highway for consumers' money after they make a purchase with one of the company's branded products. After a card is swiped, the money travels safely and quickly from the consumer's bank account to the merchant's account (minus various fees) on Mastercard's vast network. Mastercard has performed this function for so long and done it so well that little thought is given to the company's role in routing the transaction: first to the issuer for approval and then to the merchant's bank to facilitate the details of the transaction.
Mastercard does not lend money directly to consumers nor does it usually maintain any direct relationship with cardholders. That role belongs to the financial institutions that issue Mastercard-branded products. The negative to this business model is that it means that Mastercard does not collect interest on the massive amounts of debt consumers carry on their credit cards. The positive is that Mastercard is not directly exposed to credit liabilities, giving it an asset-light business model that helps it maintain an adjusted operating margin of more than 59%.
The uniqueness of this business model gives Mastercard only one real competitor in most economic markets around the world, Visa(NYSE: V), making the two a near duopoly. As a result, the two enjoy massive network effect moats, gaining value since merchants cannot refuse to accept them because so many consumers carry them, and so many consumers carry them because so many merchants accept them as payment methods. The two also enjoy a network effect moat with the financial institutions that issue their cards. Can you imagine the uproar from a bank's account holders if it were to issue a new upstart network's debit card, where no merchant accepted them and had yet to gain the trust from familiarity that consumers already have with Mastercard and Visa?
The company's network effect moat is evident when looking at its massive global scale and growth: Mastercard has 2.47 billion cards issued that were used in 18.8 billion transactions in the third quarter of 2018. Revenue went up to $3.9 billion, a 17% increase year over year, while adjusted earnings per share (EPS) rose to $1.78, a 36% increase year over year. Based on its adjusted EPS, it currently trades at a P/E ratio of just over 32.
The verdict
As I stated above, I personally own PayPal and it is one of my largest positions. E-commerce and mobile transactions continue to take over larger percentages of Americans' spending habits, two trends that directly benefit PayPal. Yet given the choice between the two, I would still invest in shares of Mastercard over PayPal at this time. PayPal will face far more challenges from competitors because there are much lower barriers to entry into the digital wallet space than there are for credit card networks. In many markets, Mastercard and Visa operate without any direct competitors. Due to the strength of Mastercard's moat, I believe it remains a better buy for investors today.
Matthew Cochrane owns shares of Mastercard and PayPal Holdings. The Motley Fool owns shares of and recommends Mastercard and PayPal Holdings. The Motley Fool owns shares of Visa and has the following options: short January 2019 $82 calls on PayPal Holdings. The Motley Fool recommends eBay. The Motley Fool has a disclosure policy.
