Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2018.
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from             to             .
Commission file number 001-36859
   
 
PayPal Holdings, Inc.
(Exact Name of Registrant as Specified in Its Charter)
 
 
Delaware
47-2989869
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
2211 North First Street
San Jose, California
95131
(Address of Principal Executive Offices)
(Zip Code)
(408) 967-1000
(Registrant’s telephone number, including area code)
  
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  [x]    No  [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  [x]    No  [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
ý 
Accelerated filer
o
Non-accelerated filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
o
 
 
Emerging growth company
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  [ ]    No  [x]
As of April 20, 2018, there were 1,187,386,825 shares of the registrant's common stock, $0.0001 par value, outstanding, which is the only class of common or voting stock of the registrant issued.
 

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PayPal Holdings, Inc.
TABLE OF CONTENTS

 
 
 
Page Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



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Table of Contents

PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

PayPal Holdings, Inc.
CONDENSED CONSOLIDATED BALANCE SHEET
 
March 31,
2018
 
December 31,
2017
 
(In millions, except par value)
 
(Unaudited)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
2,879

 
$
2,883

Short-term investments
3,427

 
2,812

Accounts receivable, net
258

 
283

Loans and interest receivable, net of allowances of $139 and $129 as of March 31, 2018 and December 31, 2017, respectively
1,579

 
1,314

Loans and interest receivable, held for sale
6,537

 
6,398

Funds receivable and customer accounts
19,162

 
18,242

Prepaid expenses and other current assets
900

 
713

Total current assets
34,742

 
32,645

Long-term investments
1,487

 
1,961

Property and equipment, net
1,523

 
1,528

Goodwill
4,338

 
4,339

Intangible assets, net
138

 
168

Other assets
94

 
133

Total assets
$
42,322

 
$
40,774

LIABILITIES AND EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
187

 
$
257

Notes payable
3,000

 
1,000

Funds payable and amounts due to customers
20,662

 
19,742

Accrued expenses and other current liabilities
1,767

 
1,781

Income taxes payable
98

 
83

Total current liabilities
25,714

 
22,863

Deferred tax liability and other long-term liabilities
1,967

 
1,917

Total liabilities
27,681

 
24,780

Commitments and Contingencies (Note 13)

 


Equity:
 
 
 
Common stock, $0.0001 par value; 4,000 shares authorized; 1,183 and 1,200 shares outstanding as of March 31, 2018 and December 31, 2017, respectively
—

 
—

Treasury stock at cost, 71 and 47 shares as of March 31, 2018 and December 31, 2017, respectively
(3,811
)
 
(2,001
)
Additional paid-in-capital
14,287

 
14,314

Retained earnings
4,334

 
3,823

Accumulated other comprehensive loss
(169
)
 
(142
)
Total equity
14,641

 
15,994

Total liabilities and equity
$
42,322

 
$
40,774

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PayPal Holdings, Inc.
CONDENSED CONSOLIDATED STATEMENT OF INCOME
 
Three Months Ended March 31,
 
2018
 
2017
 
(In millions, except per share data)
 
(Unaudited)
Net revenues
$
3,685

 
$
2,975

Operating expenses:
 
 
 
Transaction expense
1,275

 
987

Transaction and loan losses
305

 
300

Customer support and operations
351

 
317

Sales and marketing
285

 
238

Product development
258

 
214

General and administrative
339

 
265

Depreciation and amortization
185

 
183

Restructuring and other charges
153

 
40

Total operating expenses
3,151

 
2,544

Operating income
534

 
431

Other income (expense), net
14

 
7

Income before income taxes
548

 
438

Income tax expense
37

 
54

Net income
$
511

 
$
384

 
 
 
 
Net income per share:
 
 
 
Basic
$
0.43

 
$
0.32

Diluted
$
0.42

 
$
0.32

 
 
 
 
Weighted average shares:
 
 
 
Basic
1,192

 
1,203

Diluted
1,217

 
1,216

The accompanying notes are an integral part of these condensed consolidated financial statements.


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PayPal Holdings, Inc.
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
 
Three Months Ended March 31,
 
2018
 
2017
 
(In millions)
 
(Unaudited)
Net income
$
511

 
$
384

Other comprehensive (loss) income, net of reclassification adjustments:
 
 
 
Foreign currency translation
2

 
13

Unrealized (losses) gains on investments, net
(15
)
 
1

Tax benefit (expense) on unrealized (losses) gains on investments, net
4

 
—

Unrealized (losses) gains on hedging activities, net
(18
)
 
(72
)
Tax benefit (expense) on unrealized (losses) gains on hedging activities, net
—

 
1

Other comprehensive (loss) income, net of tax
(27
)
 
(57
)
Comprehensive income
$
484

 
$
327

The accompanying notes are an integral part of these condensed consolidated financial statements.


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PayPal Holdings, Inc.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
 
Three Months Ended March 31,
 
2018
 
2017
 
(In millions)
 
(Unaudited)
Cash flows from operating activities:
 
 
 
Net income
$
511

 
$
384

Adjustments:
 
 
 
Transaction and loan losses
305

 
300

Depreciation and amortization
185

 
183

Stock-based compensation
205

 
145

Deferred income taxes
91

 
53

Gain on sale of principal loans receivable held for sale, net
(5
)
 
(6
)
Cost basis adjustments to loans and interest receivable held for sale
128

 
—

Changes in assets and liabilities:
 
 
 
Accounts receivable
25

 
36

Changes in loans and interest receivable held for sale, net
(1,291
)
 
6

Accounts payable
(35
)
 
(1
)
Income taxes payable
—

 
17

Other assets and liabilities
(468
)
 
(366
)
Net cash (used in) provided by operating activities
(349
)
 
751

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(178
)
 
(148
)
Changes in principal loans receivable, net
738

 
(136
)
Purchases of investments
(5,275
)
 
(7,109
)
Maturities and sales of investments
4,291

 
5,583

Funds receivable
429

 
567

Net cash provided by (used in) investing activities
5

 
(1,243
)
Cash flows from financing activities:
 
 
 
Proceeds from issuance of common stock
13

 
12

Purchases of treasury stock
(1,825
)
 
(517
)
Tax withholdings related to net share settlements of equity awards
(335
)
 
(101
)
Borrowings under financing arrangements, net of repayments
2,075

 
—

Funds payable and amounts due to customers
865

 
552

Net cash provided by (used in) financing activities
793

 
(54
)
Effect of exchange rate changes on cash, cash equivalents and restricted cash
(7
)
 
11

Net change in cash, cash equivalents and restricted cash
442

 
(535
)
Cash, cash equivalents and restricted cash at beginning of period
8,285

 
6,119

Cash, cash equivalents and restricted cash at end of period
$
8,727

 
$
5,584

Supplemental cash flow disclosures:
 
 
 
Cash paid for interest
$
8

 
$
1

Cash paid (refund received) for income taxes, net
$
(6
)
 
$
48

 
 
 
 
The below table reconciles cash, cash equivalents and restricted cash as reported in the condensed consolidated balance sheet to the total of the same amounts shown in the condensed consolidated statements of cash flows:
 
 
 
Cash and cash equivalents
$
2,879

 
$
1,240

Short term investments
16

 
19

Funds receivable and customer accounts
5,832

 
4,325

Total cash, cash equivalents and restricted cash shown in the condensed consolidated statements of cash flows
$
8,727

 
$
5,584


The accompanying notes are an integral part of these condensed consolidated financial statements.

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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Note 1—Overview and Summary of Significant Accounting Policies

Overview and Organization

PayPal Holdings, Inc. ("PayPal," the "Company," "we," "us," or "our") was incorporated in Delaware in January 2015 and is a leading technology platform and digital payments company that enables digital and mobile payments on behalf of consumers and merchants worldwide. Our vision is to democratize financial services, as we believe that managing and moving money is a right for all people, not just the affluent. Our goal is to increase our relevance for consumers and merchants to manage and move their money anywhere in the world, anytime, on any platform and using any device. We also facilitate person-to-person payments through our PayPal, Venmo and Xoom products. Our combined payment solutions, including our PayPal, PayPal Credit, Braintree, Venmo, and Xoom products, compose our proprietary Payments Platform.

We operate globally and in a rapidly evolving regulatory environment characterized by a heightened regulatory focus on all aspects of the payments industry. That focus continues to become even more heightened as regulators on a global basis focus on such important issues as countering terrorist financing, anti-money laundering, privacy and consumer protection. Some of the laws and regulations to which we are subject were enacted recently, and the laws and regulations applicable to us, including those enacted prior to the advent of digital and mobile payments, are continuing to evolve through legislative and regulatory action and judicial interpretation. Non-compliance with laws and regulations, increased penalties and enforcement actions related to non-compliance, changes in laws and regulations or their interpretation, and the enactment of new laws and regulations applicable to us could have a material adverse impact on our business, results of operations and financial condition.

Significant Accounting Policies

Basis of Presentation and Principles of Consolidation
The condensed consolidated financial statements include the financial statements of PayPal and our wholly and majority-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Investments in entities where we hold less than a 20% ownership interest are generally accounted for at cost minus impairment, if any, plus or minus changes resulting from observable price changes, and our share of the investees’ results of operations and is included in other income (expense), net on our condensed consolidated statement of income to the extent dividends are received. Our investment balance is included in long-term investments on our condensed consolidated balance sheet.
These condensed consolidated financial statements and accompanying notes should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2017 (the "2017 Form 10-K") filed with the Securities and Exchange Commission.
In the opinion of management, these condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, which are necessary for fair presentation of the condensed consolidated financial statements for interim periods. We have evaluated all subsequent events through the date the financial statements were issued. Certain amounts for prior years have been reclassified to conform to the financial presentation as of and for the three months ended March 31, 2018.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses, during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to provisions for transaction and loan losses, loss contingencies, income taxes, revenue recognition and the valuation of goodwill and intangible assets. We base our estimates on historical experience and various other assumptions which we believe to be reasonable under the circumstances. Actual results could differ from those estimates.


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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Recent Accounting Guidance

In 2016, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance related to accounting for leases, which will require lessees to recognize lease assets and lease liabilities on the balance sheet for the rights and obligations created by all leases with terms greater than 12 months. As we are not a lessor, other changes in the guidance applicable to lessors do not apply. The guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2018, with early adoption permitted. We will adopt the new guidance on January 1, 2019, using a modified retrospective basis and anticipate applying the optional practical expedients related to the transition. We are evaluating the impact of adopting this new accounting guidance on our financial statements.

In 2016, the FASB issued new guidance on the measurement of credit losses on financial instruments. Credit losses on loans, trade and other receivables, held-to-maturity debt securities and other instruments will reflect our current estimate of the expected credit losses that generally will result in the earlier recognition of allowances for losses. Credit losses on available-for-sale debt securities with unrealized losses will be recognized as allowances for credit losses limited to the amount by which fair value is below amortized cost. Additional disclosures will be required, including information used to track credit quality by year of origination for most financing receivables. The new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. We are required to apply the provisions of this guidance as a cumulative effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted with impairment of available-for-sale debt securities applied prospectively after adoption. We are evaluating the impact and approach to adopting this new accounting guidance on our financial statements.

In 2017, the FASB issued new guidance that requires certain premiums on callable debt securities to be amortized to the earliest call date. The amortization period for callable debt securities purchased at a discount will not be impacted.  Therefore, the new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. Transition is on a modified retrospective basis with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We are evaluating the impact this new accounting guidance will have on our financial statements.

In 2018, the FASB issued new guidance in response to tax reform that allows the option to reclassify stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017 (the "Tax Act") from accumulated other comprehensive income to retained earnings. The new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. If such an option is elected, transition can be applied either retrospectively to each period in which the effect of tax reform is recognized or applied with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We are evaluating the impact this new accounting guidance will have on our financial statements.

Recently Adopted Accounting Guidance

In 2014, the FASB issued new accounting guidance related to revenue recognition, which was further updated in 2016 for reporting revenue gross versus net. This new guidance replaced all existing GAAP guidance on this topic and eliminated all industry-specific guidance. The new revenue recognition guidance provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration for which the entity expects to be entitled in exchange for those goods or services. We adopted the guidance effective January 1, 2018 on a full retrospective basis. We performed an impact analysis for the opening balance sheet as of January 1, 2016 as well as for the years ended December 31, 2016 and 2017. The impacts were deemed de minimis. No practical expedients or exemptions were elected in conjunction with the adoption of this new guidance. For additional information, see "Note 2—Revenue."

In 2016, the FASB issued new accounting guidance related to the classification and measurement of financial instruments. This new guidance amends GAAP by requiring equity investments to be measured at fair value with changes in fair value recognized in net income. This new guidance also amends the presentation of certain fair value changes for financial liabilities measured at fair value and it amends certain disclosure requirements associated with the fair value of financial instruments. Additionally, in 2018, the FASB issued technical corrections and improvements to this guidance effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years beginning after June 15, 2018. We are required to apply the new guidance on a modified retrospective basis to all outstanding instruments, with a cumulative effect adjustment as of the date of adoption and on a prospective basis to all outstanding equity investments without a readily determinable fair value. We adopted the guidance,

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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

including early adoption of the technical corrections and improvements, effective January 1, 2018. Beginning in the first quarter of 2018, we applied the measurement alternative to all our equity investments, which required us to measure these equity investments at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar investment in the same issuer. The adoption of this guidance did not have a material impact on our financial statements.

In 2016, the FASB issued new guidance on classifying certain cash receipts and cash payments on the statement of cash flows. The new guidance addresses the classification of cash flows related to: debt prepayment or extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance, including bank-owned life insurance, distributions received from equity method investees and beneficial interests in securitization transactions. The guidance also clarifies how the predominance principle should be applied when cash receipts and cash payments have aspects of more than one class of cash flows. The guidance should be applied retrospectively after adoption. We adopted the guidance effective January 1, 2018. The adoption of this guidance did not have a material impact on our financial statements.

In 2016, the FASB issued new guidance on restricted cash on the statement of cash flows. The new guidance requires the classification and presentation of changes in restricted cash and cash equivalents in the statement of cash flows. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning and ending balances shown on the statement of cash flows. The guidance should be applied retrospectively after adoption. We adopted the guidance effective January 1, 2018 on a retrospective basis. The beginning and ending balances of cash and cash equivalents on the statement of cash flows now include restricted cash and restricted cash equivalents, such as cash and cash equivalents underlying customer accounts and restricted cash and restricted cash equivalents within short-term investments.

In 2017, the FASB issued new guidance clarifying the scope and application of the de-recognition of non-financial assets and the sale or transfer of non-financial assets, including partial sales. We adopted the guidance effective January 1, 2018 on a full retrospective basis. The adoption of this guidance did not have a material impact on our financial statements.

In 2017, the FASB issued new guidance clarifying which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. Specifically, an entity would apply modification accounting only if the fair value, vesting conditions, or classification of the awards changes as a result of changes in the terms or conditions. We adopted the guidance effective January 1, 2018 and applied it prospectively upon adoption. The adoption of this guidance did not have a material impact on our financial statements.

In 2017, the FASB issued new guidance intended to better align the results of hedge accounting with an entity’s risk management activities. This guidance updates the designation and measurement guidance for qualifying hedging relationships by expanding hedge accounting for both nonfinancial and financial risk components and by refining the measurement of hedge results to better reflect an entity’s hedging strategies. The amendments will also align the recognition and presentation of the effects of the hedge results in the financial statements to increase the understandability of the results of an entity’s intended hedging strategies. Additionally, the guidance includes certain targeted improvements to ease the operational burden of applying hedge accounting. We are required to apply the guidance with a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year in which the guidance is adopted and prospectively apply the presentation and disclosure guidance. We early adopted the guidance in the first quarter of 2018 using a modified retrospective approach to reflect application of the new guidance effective January 1, 2018. Adoption of the guidance did not have a material impact on our financial statements.

In 2018, the FASB issued new guidance to provide clarity around application of income tax accounting in situations where the assessment of tax implications of the Tax Act might not be complete as of period end in which the Tax Act was enacted. This guidance prescribes that an entity must reflect the income tax impact of the Tax Act in the period in which the tax accounting is complete and allows an entity to report provisional amounts for those specific effects of the Act for which the accounting is incomplete but a reasonable estimate can be determined. No provisional amounts should be reported for specific effects of the Tax Act for which a reasonable estimate cannot be determined, and the entity should continue to apply the provisions of the tax laws that were in effect prior to the enactment of the Tax Act. It further allows a measurement period of one year from the date of enactment within which to complete the accounting for all impacts of the Tax Act. Our financial statements reflect tax accounting in compliance with this guidance.


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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 2—Revenue

We earn revenue primarily by processing customer transactions on our Payments Platforms and from other value added services. Our revenues are classified into two categories, transaction revenues and revenues from other value added services:
Transaction Revenues
We earn transaction revenues primarily from fees charged to consumers and merchants on a transaction basis. These fees may have a fixed and variable component. The variable component is generally a percentage of the value of the payment amount, and is known at the time the transaction is processed. If the underlying transaction is approved for refund, we reimburse the variable component of the fee. We estimate the amount of fee refunds that will be processed during the quarter and record a provision against our net revenues. The volume of activity processed through our Payments Platform, which results in transaction revenue, is referred to as Total Payments Volume (“TPV”). We define TPV as the value of payments, net of reversals, successfully completed through our Payments Platform or enabled by PayPal via a partner payment solution, not including gateway-exclusive transactions. We earn additional fees on transactions where we perform a currency conversion and when we enable cross-border transactions (i.e., transactions where the merchant and consumer are in different countries).

Our contracts with our customers are usually open ended and can be terminated by either party without a termination penalty after the notice period has lapsed. Therefore, our contracts are defined at the transaction level and do not extend beyond the service already provided. Our contracts renew automatically without significant material rights. Some of our contracts include tiered pricing, based primarily on volume. The fee charged per transaction is adjusted up or down if the volume processed for a specified period is different from prior period defined volumes. We have concluded that this volume-based pricing approach does not constitute a future material right since the discount is within a range typically offered to class of customers with similar volume. We provide account set up and payment-processing services and account for these services as one performance obligation satisfied at a point in time when the payment transaction is complete. The transaction price is therefore fully allocated to one performance obligation. We deduct our fees from the transaction payment processed. We do not have any capitalized contract costs, and do not carry any contract balances.

We recognize fees charged to our customers primarily on a gross basis as transaction revenue when we are the principal in respect of processing payments. As a principal to the transaction, we bear primary responsibility for the fulfillment of the payment service, contract directly with our customers, control the product specifications and define the value proposal from our services. Further, we have full discretion in determining the fee charged to our customers, and therefore, we bear the full margin risk. We are also responsible for providing customer support. Related transaction costs paid to our payment processors and other financial institutions are recognized as transaction expense.

We provide merchants and consumers with protection programs on substantially all transactions completed through our Payments Platforms, except for transactions using our gateway products. These programs protect both merchants and consumers from loss primarily due to fraud and counterparty performance. Our buyer protection program provides protection to consumers for qualifying purchases by reimbursing the consumer for the full amount of the purchase if a purchased item does not arrive or does not match the seller’s description. Our seller protection programs provide protection to merchants against claims that a transaction was not authorized by the buyer or claims that an item was not received by covering the seller for the full amount of the payment on eligible sales. These protection programs are considered standard service warranties for which we estimate and record associated costs in transaction and loan losses during the period the payment transaction is processed.
Revenues from Other Value Added Services
We earn revenues from other value added services which comprise revenue earned through partnerships, subscription fees, gateway fees, and other services that we provide to our consumers and merchants. The contracts for these services cannot usually be terminated by either party without penalty. These contracts typically have one performance obligation which is provided and recognized over the term of the contract. The transaction price is generally fixed and known at the end of each reporting period, however, for some agreements, it may be necessary to estimate the transaction price using the expected value method.
We recognize revenue received from our financial institution partners on a net basis when we are considered the agent in respect of processing transactions. As we are an agent to the transaction, our financial institution partners directly contract with the end customers and are ultimately responsible for the fulfillment of the services. In an agent relationship, we may have some discretion in determining the fee charged to end customers, but always in conjunction with a financial institution partner. As a result, related costs incurred by our financial institution partners when we are an agent are included as a reduction to the revenue share received.

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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

We also earn revenues from interest and fees earned on our loans receivable portfolio, gain on sale of participation interest in certain loans and advances and interest earned on certain PayPal customer account balances. Interest and fees earned on the PayPal credit portfolio of loans receivable are computed and recognized based on contractual interest and fee rates, and are net of any required reserves and amortization of deferred origination costs.
Disaggregation of Revenue

We determine operating segments based on how our chief operating decision maker (“CODM”) manages the business, makes operating decisions around the allocation of resources and evaluates operating performance. Our CODM is our Chief Executive Officer, who reviews our operating results on a consolidated basis. We operate in one segment and have one reportable segment. Based on the information provided to and reviewed by our CODM, we believe that the nature, amount, timing and uncertainty of our revenue and cash flows and how they are affected by economic factors is most appropriately depicted through our primary geographical markets and type of revenue (transaction and other value added services) categories. Revenues recorded within these categories are earned from similar services for which the nature of associated fees and the related revenue recognition models are substantially the same.

The following table presents our revenues disaggregated by primary geographical markets:
 
Three Months Ended March 31,
 
2018
  
2017
 
(In millions)
Primary geographical markets
 
 
 
United States ("U.S.")
$
2,023

 
$
1,606

United Kingdom ("U.K.")
392

 
313

Other countries(1)
1,270

 
1,056

Total revenues(2)
$
3,685

 
$
2,975

 
 
 
 
Types of revenues
 
 
 
Transaction revenues
$
3,197

 
$
2,624

Other value added services
488

 
351

Total revenues(2)
$
3,685

 
$
2,975

(1) No single country included in the other countries category generated more than 10% of total revenue.
(2) Total revenues include interest, fees and gains earned on loan and interest receivables, net and held for sale portfolio, as well as hedging gains or losses and interest earned on certain PayPal customer balances of $359 million and $307 million for the three months ended March 31, 2018 and 2017, respectively, which do not represent revenues recognized in the scope of ASC Topic 606, Revenue from contracts with customers.

Net revenues are attributed to the U.S., the U.K. and other countries primarily based upon the country in which the merchant is located, or in the case of a cross-border transaction, may be earned from the country in which the consumer and the merchant respectively reside. Net revenues earned from value added services are typically attributed to the country in which either the customer or partner reside.

Note 3—Net Income Per Share
Basic net income per share is computed by dividing net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income for the period by the weighted average number of shares of common stock and potentially dilutive common stock outstanding for the period. The dilutive effect of outstanding equity incentive awards is reflected in diluted net income per share by application of the treasury stock method. The calculation of diluted net income per share excludes all anti-dilutive common shares.

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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The following table sets forth the computation of basic and diluted net income per share for the periods indicated:
 
Three Months Ended March 31,
 
2018
  
2017
 
(In millions, except per share amounts)
Numerator:
 
 
 
Net income
$
511

 
$
384

Denominator:
 
 
 
Weighted average shares of common stock - basic
1,192

 
1,203

Dilutive effect of equity incentive awards
25

 
13

Weighted average shares of common stock - diluted
1,217

 
1,216

Net income per share:
 
 
 
Basic
$
0.43

 
$
0.32

Diluted
$
0.42

 
$
0.32

Common stock equivalents excluded from income per diluted share because their effect would have been anti-dilutive
—

 
6


Note 4—Business Combinations
There were no acquisitions or divestitures completed in either the three months ended March 31, 2018 or 2017.

Note 5—Goodwill and Intangible Assets

Goodwill

The following table presents goodwill balances and adjustments to those balances during the three months ended March 31, 2018:
 
December 31,
2017
 
Goodwill
Acquired
 
Adjustments
 
March 31,
2018
 
 (In millions)
Total goodwill
$
4,339

 
$
—

 
$
(1
)
 
$
4,338


Intangible Assets

The components of identifiable intangible assets are as follows:
 
March 31, 2018
 
December 31, 2017
 
Gross Carrying Amount  
 
Accumulated Amortization 
 
Net Carrying Amount
 
Weighted Average Useful Life (Years)
 
Gross Carrying Amount 
 
Accumulated Amortization 
 
Net Carrying Amount
 
Weighted Average Useful Life (Years)
 
(In millions, except years)
Intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Customer lists and user base
$
613

 
$
(574
)
 
$
39

 
3
 
$
613

 
$
(563
)
 
$
50

 
3
Marketing related
198

 
(197
)
 
1

 
1
 
198

 
(196
)
 
2

 
1
Developed technologies
274

 
(227
)
 
47

 
3
 
274

 
(215
)
 
59

 
3
All other
245

 
(194
)
 
51

 
5
 
245

 
(188
)
 
57

 
5
Intangible assets, net
$
1,330

 
$
(1,192
)
 
$
138

 
 
 
$
1,330

 
$
(1,162
)
 
$
168

 
 

12
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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

        
Amortization expense for intangible assets was $30 million and $27 million for the three months ended March 31, 2018 and 2017, respectively.

Expected future intangible asset amortization as of March 31, 2018 was as follows (in millions):
Fiscal years:
 
Remaining 2018
$
69

2019
42

2020
27

 
$
138


Note 6—Geographical Information

The following table summarizes long-lived assets based on geography:

 
March 31,
2018
  
December 31,
2017
 
(In millions)
Long-lived assets:
 
 
 
U.S.
$
1,422

 
$
1,432

Other countries
101

 
96

Total long-lived assets
$
1,523

 
$
1,528


Tangible long-lived assets as of March 31, 2018 and December 31, 2017 consisted of property and equipment. Long-lived assets attributed to the U.S. and other countries are based upon the country in which the asset is located or owned.

Note 7—Funds Receivable and Customer Accounts

The following table summarizes the assets underlying our funds receivable and customer accounts as of March 31, 2018 and December 31, 2017.
 
March 31,
2018
 
December 31,
2017
 
(In millions)
Cash and cash equivalents
$
5,832

 
$
5,387

Government and agency securities
8,036

 
6,651

Time deposits
373

 
739

Corporate debt securities
1,129

 
1,248

Funds receivable
3,792

 
4,217

Total funds receivable and customer accounts
$
19,162

 
$
18,242



13
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

As of March 31, 2018 and December 31, 2017, the estimated fair value of our investments classified as available-for-sale included within funds receivable and customer accounts was as follows:
 
March 31, 2018
 
Gross
Amortized
Cost
  
Gross
Unrealized
Gains
  
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(In millions)
Government and agency securities
$
6,962

 
$
—

 
$
(6
)
 
$
6,956

Corporate debt securities
392

 
—

 
(1
)
 
391

Total
$
7,354

 
$
—

 
$
(7
)
 
$
7,347


 
December 31, 2017
 
Gross
Amortized
Cost
  
Gross
Unrealized
Gains
  
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(In millions)
Government and agency securities
$
5,946

 
$
—

 
$
(5
)
 
$
5,941

Corporate debt securities
529

 
—

 
—

 
529

Total
$
6,475

 
$
—

 
$
(5
)
 
$
6,470


We elect to account for certain investments within customer accounts, including foreign-currency denominated available-for-sale investments, under the fair value option. As a result, any gains and losses from fair value changes on such investments are recognized in other income (expense), net on the condensed consolidated statement of income. Election of the fair value option allows us to significantly reduce the accounting asymmetry that would otherwise arise when recognizing the changes in the fair value of available-for-sale investments and the corresponding foreign exchange gains and losses relating to customer liabilities. As of March 31, 2018 and December 31, 2017, the estimated fair value of our investments included within funds receivable and customer accounts under the fair value option was $1.8 billion and $1.4 billion, respectively. In the three months ended March 31, 2018 and 2017, $40 million and $15 million of net gains from fair value changes, respectively, were recognized in other income (expense), net on the condensed consolidated statement of income.

The aggregate fair value of investments in an unrealized loss position was $6.4 billion as of March 31, 2018 and $6.0 billion as of December 31, 2017. The aggregate gross unrealized loss on our short-term and long-term investments was not material as of March 31, 2018 and December 31, 2017. We believe the decline in value is due to temporary market conditions and expect to recover the entire amortized cost basis of the securities. We neither intend nor anticipate the need to sell the securities before recovery. We will continue to monitor the performance of the investment portfolio and assess market and interest rate risk when evaluating whether other-than-temporary impairment exists.

As of March 31, 2018 and December 31, 2017, we had no material investments that had been in a continuous unrealized loss position for greater than 12 months. Amounts reclassified to earnings from unrealized gains and losses were not material for the three months ended March 31, 2018 and 2017.

The estimated fair values of our investments classified as available-for-sale included within funds receivable and customer accounts by date of contractual maturity at March 31, 2018 were as follows:
 
March 31,
2018
 
(In millions)
One year or less
$
7,292

One year through two years
26

Two years through three years
29

Total
$
7,347



14
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 8—Investments

As of March 31, 2018 and December 31, 2017, the estimated fair value of our short-term and long-term investments classified as available-for-sale was as follows:
 
March 31, 2018
 
Gross
Amortized
Cost
  
Gross
Unrealized
Gains
  
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(In millions)
Short-term investments(1)(2):
 
  
 
  
 
 
 
Corporate debt securities
$
2,340

 
$
—

 
$
(4
)
 
$
2,336

Government and agency securities
495

 
—

 
(1
)
 
494

Long-term investments(1):
 
 
 
 
 
 


Corporate debt securities
1,324

 
1

 
(16
)
 
1,309

Government and agency securities
88

 
—

 
—

 
88

Total(1)(2)
$
4,247

 
$
1

 
$
(21
)
 
$
4,227

(1) Excludes short-term restricted cash of $81 million that we intend to use to support our global sabbatical program and a counterparty guarantee, and long-term restricted cash of $2 million.
(2) Excludes time deposits of $199 million, which are not considered available-for-sale securities.

 
December 31, 2017
 
Gross
Amortized
Cost
  
Gross
Unrealized
Gains
  
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(In millions)
Short-term investments(1)(2):
 
  
 
  
 
 
 
Corporate debt securities
$
2,092

 
$
1

 
$
(1
)
 
$
2,092

Government and agency securities
210

 
—

 
—

 
210

Long-term investments(1):
 
 
 
 
 
 
 
Corporate debt securities
1,769

 
2

 
(7
)
 
1,764

Government and agency securities
98

 
—

 
—

 
98

Total(1)(2)
$
4,169

 
$
3

 
$
(8
)
 
$
4,164

(1) Excludes short-term restricted cash of $79 million that we intend to use to support our global sabbatical program and a counterparty guarantee, and long-term restricted cash of $2 million.
(2) Excludes time deposits of $163 million, which are not considered available-for-sale securities.

We elected to account for foreign denominated available-for-sale investments held in our Luxembourg banking subsidiary under the fair value option. Election of the fair value option allows us to recognize any gains and losses from fair value changes on such investments in other income (expense), net on the condensed consolidated statement of income to offset certain foreign exchange gains and losses on our foreign denominated customer liabilities. As of March 31, 2018 and December 31, 2017, the estimated fair value of our investments included within short-term investments and long-term investments under the fair value option was $317 million and $277 million, respectively. In the three months ended March 31, 2018 and 2017, $8 million and $6 million, respectively, of net gains from fair value changes were recognized in other income (expense), net on the condensed consolidated statement of income.

The aggregate fair value of short-term and long-term investments in an unrealized loss position was $3.4 billion as of March 31, 2018 and $2.8 billion as of December 31, 2017, of which $206 million and $207 million, respectively, was in a continuous unrealized loss position for greater than 12 months. The aggregate gross unrealized loss on our short-term and long-term investments was not material as of March 31, 2018 and December 31, 2017. We believe the decline in value is due to temporary market conditions and expect to recover the entire amortized cost basis of the securities. We neither intend nor anticipate the need to sell the securities before recovery. We will continue to monitor the performance of the investment portfolio and assess market and interest rate risk when evaluating whether other-than-temporary impairment exists. Amounts reclassified to earnings from unrealized gains and losses were not material for the three months ended March 31, 2018 and 2017.


15
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The estimated fair values of our short-term and long-term investments classified as available-for-sale by date of contractual maturity at March 31, 2018 were as follows:
 
March 31, 2018
 
(In millions)
One year or less
$
2,830

One year through two years
823

Two years through three years
344

Three years through four years
171

Four years through five years
49

Greater than five years
10

Total
$
4,227


Other Investments

We have equity investments which consist primarily of minority equity interests in companies that are not publicly traded and are reported in long-term investments on our condensed consolidated balance sheet. Our equity investments totaled $88 million as of March 31, 2018 and December 31, 2017.

Note 9—Fair Value Measurement of Assets and Liabilities

Financial Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis

The following tables summarize our financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2018 and December 31, 2017:

 
March 31, 2018
 
 
Significant Other
Observable Inputs
(Level 2)
 
 
(In millions)
Assets:
 
 
 
 
 
Cash and cash equivalents(1)
 
$
1,104

 
 
$
1,104

Short-term investments(2):
 
 
 
 
 
Corporate debt securities
 
2,419

 
 
2,419

Government and agency securities
 
728

 
 
728

Total short-term investments
 
$
3,147

 
 
$
3,147

Funds receivable and customer accounts(3)
 
9,424

 
 
9,424

Derivatives
 
56

 
 
56

Long-term investments(2):
 
 
 
 
 
Corporate debt securities
 
1,309

 
 
1,309

Government and agency securities
 
88

 
 
88

Total long-term investments
 
1,397

 
 
1,397

Total financial assets
 
$
15,128

 
 
$
15,128

Liabilities:
 
 
 
 
 
Derivatives
 
$
197

 
 
$
197

(1) Excludes cash of $1.8 billion not subject to fair value measurement on a recurring basis.
(2) Excludes restricted cash of $83 million, time deposits of $199 million, and equity investments of $88 million not subject to fair value measurement on a recurring basis.
(3) Excludes cash, time deposits and funds receivable of $9.7 billion underlying funds receivable and customer accounts not subject to fair value measurement on a recurring basis.

16
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


 
December 31, 2017
 
 
Significant Other
Observable Inputs
(Level 2)
 
 
(In millions)
Assets:
 
 
 
 
 
Cash and cash equivalents(1)
 
$
791

 
 
$
791

Short-term investments(2):
 
 
 
 
 
Corporate debt securities
 
2,219

 
 
2,219

Government and agency securities
 
351

 
 
351

Total short-term investments
 
2,570

 
 
2,570

Funds receivable and customer accounts(3)
 
8,007

 
 
8,007

Derivatives
 
66

 
 
66

Long-term investments(2):
 
 
 
 
 
Corporate debt securities
 
1,773

 
 
1,773

Government and agency securities
 
98

 
 
98

Total long-term investments
 
1,871

 
 
1,871

Total financial assets
 
$
13,305

 
 
$
13,305

Liabilities:
 
 
 
 
 
Derivatives
 
$
218

 
 
$
218

(1) Excludes cash of $2.1 billion not subject to fair value measurement on a recurring basis.
(2) Excludes restricted cash of $81 million, time deposits of $163 million, and equity investments of $88 million not subject to fair value measurement on a recurring basis.
(3) Excludes cash, time deposits and funds receivable of $10.2 billion underlying funds receivable and customer accounts not subject to fair value measurement on a recurring basis.

Our financial assets and liabilities are valued using market prices on both active markets (Level 1) and less active markets (Level 2). Level 1 instrument valuations are obtained from real-time quotes for transactions in active exchange markets involving identical assets. Level 2 instrument valuations are obtained from readily available pricing sources for comparable instruments, identical instruments in less active markets, or models using market observable inputs.

A majority of our derivative instruments are valued using pricing models that take into account the contract terms as well as multiple inputs where applicable, such as currency rates, interest rate yield curves, option volatility and equity prices. Our derivative instruments are primarily short-term in nature, generally one month to one year in duration. Certain foreign currency contracts designated as cash flow hedges may have a duration of up to 18 months.

We did not have any transfers of financial instruments between valuation levels during the three months ended March 31, 2018 and 2017. As of March 31, 2018, we did not have any assets or liabilities requiring measurement at fair value without observable market values that would require a high level of judgment to determine fair value (Level 3).

Cash and cash equivalents are short-term, highly liquid investments with original maturities of three months or less when purchased and are comprised primarily of bank deposits, government and agency securities and commercial paper.

We elect to account for foreign currency denominated available-for-sale investments underlying funds receivable and customer accounts, short term investments and long term investments under the fair value option as further discussed in "Note 7—Funds Receivable and Customer Accounts" and "Note 8—Investments."


17
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Financial Assets and Liabilities Not Measured and Recorded at Fair Value

Our financial instruments, including cash, time deposits, accounts receivable, loans and interest receivable, net, loans and interest receivable held for sale, funds receivable, certain customer accounts, accounts payable, notes payable, and funds payable and amounts due to customers are carried at cost, which approximates their fair value due to the short-term maturity of these instruments. If these financial instruments were measured at fair value in the financial statements, cash would be classified as Level 1, time deposits, certain customer accounts, and notes payable would be classified as Level 2, and the remaining financial instruments would be classified as Level 3 in the fair value hierarchy.

Note 10—Derivative Instruments

Summary of Derivative Instruments

Our primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. Our derivatives expose us to credit risk to the extent that our counterparties may be unable to meet the terms of the arrangement. We seek to mitigate such risk by limiting our counterparties to, and by spreading the risk across, major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored on an ongoing basis.

Foreign Exchange Contracts

We transact in various foreign currencies and have significant international revenues and costs denominated in foreign currencies, which subjects us to foreign currency risk. We have a foreign currency exposure management program whereby we designate certain foreign currency exchange contracts, generally with maturities of 18 months or less, to reduce the volatility of cash flows primarily related to forecasted revenues and expenses denominated in foreign currencies. The objective of the foreign exchange contracts is to help mitigate the risk that the U.S. dollar-equivalent cash flows are adversely affected by changes in the applicable U.S. dollar/foreign currency exchange rate. These derivative instruments are designated as cash flow hedges and accordingly, the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income (loss) and subsequently reclassified into revenue in the same period the forecasted transaction affects earnings. We evaluate the effectiveness of our foreign exchange contracts on a quarterly basis by comparing the change in the fair value of the derivative instruments with the change in the fair value of the forecasted cash flows of the hedged item. We did not exclude any component of the changes in fair value of the derivative instruments from the assessment of hedge effectiveness. We do not use any foreign exchange contracts for trading or speculative purposes.

As of March 31, 2018, we estimated that $126 million of net derivative losses related to our cash flow hedges included in accumulated other comprehensive income will be reclassified into earnings within the next 12 months. During the three months ended March 31, 2018 and 2017, we did not discontinue any cash flow hedges because it was probable that the original forecasted transaction would not occur and as such, did not reclassify any gains or losses to earnings. If we elect to discontinue our cash flow hedges and it is probable that the original forecasted transaction will occur, we continue to report them in accumulated other comprehensive income (loss) until the forecasted transaction affects earnings at which point we also reclassify the de-designated hedges into earnings. Gains and losses on derivatives held after we discontinue our cash flow hedge and gains and losses on derivative instruments that are not designated as cash flow hedges are recorded in the same financial statement line item to which the derivative relates.

We have an additional foreign currency exposure management program whereby we use foreign exchange contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the functional currency of our subsidiaries. These contracts are not designated as hedging instruments and reduce, but do not entirely eliminate, the impact of currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on our assets and liabilities are recorded in other income (expense), net, which is offset by the gains and losses on the foreign exchange contracts.


18
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Fair Value of Derivative Contracts

The fair value of our outstanding derivative instruments as of March 31, 2018 and December 31, 2017 was as follows:
 
Balance Sheet Location
 
March 31,
2018
 
December 31,
2017
 
 
 
(In millions)
Derivative Assets:
 
 
 
 
 
Foreign exchange contracts designated as cash flow hedges
Other current assets
 
$
5

 
$
—

Foreign exchange contracts not designated as hedging instruments
Other current assets
 
51

 
66

Total derivative assets
 
 
$
56

 
$
66

 
 
 
 
 
 
Derivative Liabilities:
 
 
 
 
 
Foreign exchange contracts designated as cash flow hedges
Other current liabilities
 
$
122

 
$
94

Foreign exchange contracts not designated as hedging instruments
Other current liabilities
 
75

 
124

Total derivative liabilities
 
 
$
197

 
$
218

 
 
 
 
 
 
Net fair value of derivative instruments
 
 
$
(141
)
 
$
(152
)

Master Netting Agreements - Rights of Setoff

Under master netting agreements with respective counterparties to our foreign exchange contracts, subject to applicable requirements, we are allowed to net settle transactions of the same type with a single net amount payable by one party to the other.
However, we have elected to present the derivative assets and derivative liabilities on a gross basis in our condensed consolidated balance sheet. Rights of setoff associated with our foreign exchange contracts represented a potential offset to both assets and liabilities by $52 million as of March 31, 2018 and $56 million as of December 31, 2017. During the year ended December 31, 2017, we entered into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We posted $70 million and $38 million of cash collateral related to our derivative liabilities as of March 31, 2018 and December 31, 2017, respectively, which is recognized in other current assets on our condensed consolidated balance sheet and is related to the right to reclaim cash collateral. We received $6 million in counterparty cash collateral related to our derivative assets as of March 31, 2018 which is recognized in other current liabilities on our condensed consolidated balance sheet and is related to the obligation to return cash collateral. We did not receive any counterparty cash collateral as of December 31, 2017. 

Effect of Derivative Contracts on Accumulated Other Comprehensive Income (Loss)

The following table summarizes the activity of derivative contracts that qualify for hedge accounting as of March 31, 2018 and December 31, 2017, and the impact of designated derivative instruments on accumulated other comprehensive income (loss) for the three months ended March 31, 2018 and 2017:
 
December 31, 2017
 
Amount of gains (losses)
recognized in other
comprehensive income
 
Less: Amount of gains (losses)
reclassified from
accumulated other
comprehensive income
to net revenue
 
March 31, 2018
 
(In millions)
Foreign exchange contracts designated as cash flow hedges
$
(111
)
 
$
(62
)
 
$
(44
)
 
$
(129
)



19
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
December 31, 2016
 
Amount of gains (losses)
recognized in other
comprehensive income
 
Less: Amount of gains (losses)
reclassified from
accumulated other
comprehensive income
to net revenue
 
March 31, 2017
 
(In millions)
Foreign exchange contracts designated as cash flow hedges
$
131

 
$
(32
)
 
$
40

 
$
59

 
Effect of Derivative Contracts on Condensed Consolidated Statements of Income
The following table provides the location in the condensed consolidated statements of income and amount of the recognized gains or losses related to our derivative instruments designated as hedging instruments:
 
Three Months Ended March 31,
 
2018
 
2017
 
(In millions)
 
Revenue
 
Revenue
Total amounts presented in the condensed consolidated statement of income in which the effects of cash flow hedges are recorded
$
3,685

 
$
2,975

Gains (losses) on foreign exchange contracts designated as cash flow hedges reclassified from accumulated other comprehensive income into net income
$
(44
)
 
$
40


The following table provides the location in the condensed consolidated statements of income and amount of the recognized gains or losses related to our derivative instruments not designated as hedging instruments:
 
Three Months Ended March 31,
 
2018
 
2017
 
(In millions)
Gains (losses) on foreign exchange contracts recognized in other income (expense), net
$
(44
)
 
$
(40
)
Gains (losses) on foreign exchange contracts recognized in net revenues
(6
)
 
$
—

Total gains (losses) recognized from foreign exchange contracts not designated as hedging instruments
$
(50
)
 
$
(40
)


Notional Amounts of Derivative Contracts

Derivative transactions are measured in terms of the notional amount; however, this amount is not recorded on the balance sheet and is not, when viewed in isolation, a meaningful measure of the risk profile of the derivative instruments. The notional amount is generally not exchanged, but is used only as the underlying basis on which the value of foreign exchange payments under these contracts is determined. The following table provides the notional amounts of our outstanding derivatives:
 
March 31, 2018
 
December 31, 2017
 
(In millions)
Foreign exchange contracts designated as cash flow hedges
$
3,309

 
$
2,639

Foreign exchange contracts not designated as hedging instruments
6,515

 
5,669

Total
$
9,824

 
$
8,308



20
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 11—Loans and Interest Receivable

We offer credit products to consumers and certain small and medium-sized merchants. We work with independent chartered financial institutions that extend credit to the consumer or merchant using our credit products in the U.S. For our consumer credit products outside the U.S., we extend credit through our Luxembourg banking subsidiary. For our merchant credit products outside the U.S., we extend working capital advances in the U.K. through our Luxembourg banking subsidiary, and we extend working capital loans in Australia through an Australian subsidiary. We purchase the related receivables extended by an independent chartered financial institution and are responsible for servicing functions related to all our credit products. During the three months ended March 31, 2018 and 2017, we purchased approximately $3.0 billion and $2.1 billion, respectively, in credit receivables.

Loans and Interest Receivable, Held for Sale

In November 2017, we reached an agreement to sell our U.S. consumer credit receivables portfolio to Synchrony Bank. Historically, this portfolio was reported as outstanding principal balances, net of any participation interest sold and pro-rata allowances, including unamortized deferred origination costs and estimated collectible interest and fees. Upon approval of our Board of Directors to sell these receivables, the portfolio was reclassified as held for sale and recorded at the lower of cost or fair value, determined on an aggregate basis. As of March 31, 2018 and December 31, 2017, the total outstanding balance in our held for sale portfolio was $6.5 billion and $6.4 billion, respectively, net of the participation interest sold to an independent chartered financial institution and other investors of $1.1 billion and $1.1 billion, respectively.

We use consumer FICO scores, where available, among other measures, in evaluating the credit quality of our U.S. PayPal Credit consumer receivables, held for sale. A FICO score is a type of credit score that lenders use to assess an applicant's credit risk and whether to extend credit. Individual FICO scores are generally obtained each quarter in which the U.S. consumer has an outstanding consumer receivable that we own. The weighted average U.S. consumer FICO scores related to our loans and interest receivable, held for sale balance outstanding at March 31, 2018 and December 31, 2017 was 679 and 680, respectively.

As of March 31, 2018 and December 31, 2017, approximately 50.4% and 51.1%, respectively, of the pool of loans and interest receivable, held for sale was due from U.S. consumers with FICO scores greater than or equal to 680, which is generally considered "prime" by the consumer credit industry. As of March 31, 2018 and December 31, 2017, approximately 12.3% and 11.7%, respectively, of the pool of loans and interest receivable, held for sale was due from U.S. customers with FICO scores below 599.

21
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The following table presents the principal amount of U.S. consumer loans and interest receivable segmented by a FICO score range:
 
March 31, 2018
  
December 31, 2017
 
(In millions)
> 760
$
812

 
$
832

680 - 759
2,474

 
2,439

600 - 679
2,432

 
2,378

< 599
804

 
752

Total
$
6,522

 
$
6,401


FICO score segmentation included in the table above provides the credit quality of these receivables for comparative purposes only.

The following table presents the delinquency status of U.S. consumer loans and interest receivable, held for sale. The amounts shown below are based on the number of days past the billing date to the consumer. Current represents balances that are within 30 days of the billing date. As of March 31, 2018 and December 31, 2017, approximately 91.9% and 90.6%, respectively, of the portfolio of U.S. consumer loans and interest receivable, held for sale was current.

March 31, 2018(1)
(In millions)
Current
 
30 - 59 Days
 
60 - 89 Days
 
90 - 180 Days
 
Total Past 30 days
 
Total
$
5,994

 
$
208

 
$
88

 
$
232

 
$
528

 
$
6,522

(1) Includes approximately $31 million of U.S. consumer loans and interest receivables not designated as held for sale that are fully reserved and are expected to be charged off, and excludes approximately $46 million related to accrued unbilled interest.
December 31, 2017(1)
(In millions)
Current
 
30 - 59 Days
 
60 - 89 Days
 
90 - 180 Days
 
Total Past 30 days
 
Total
$
5,800

 
$
240

 
$
103

 
$
258

 
$
601

 
$
6,401

(1) Includes approximately $50 million of U.S. consumer loans and interest receivables not designated as held for sale that are fully reserved and are expected to be charged off, and excludes approximately $47 million related to accrued unbilled interest.

No allowances are recorded for potential losses against the loans and interest receivable, held for sale portfolio. Adjustments to the cost basis of the held for sale portfolio, which are primarily driven by charge-offs, are recorded as incurred and recognized in restructuring and other charges in our consolidated statement of income.

Loans and Interest Receivable, Net

Consumer Receivables

We offer credit products to consumers who choose PayPal Credit as their funding source at checkout. As of March 31, 2018 and December 31, 2017, the outstanding balance in our pool of consumer receivables that excludes amounts classified as held for sale and primarily consists of loans and interest receivable due from international consumer accounts was $403 million and $326 million, respectively.

We closely monitor credit quality for our international consumer receivables to manage and evaluate our related exposure to credit risk. Credit risk management begins with initial underwriting and continues through to full repayment of a loan. To assess a consumer who requests a loan, we use, among other indicators, internally developed risk models using detailed information from external sources such as credit bureaus where available and internal historical experience including the consumer’s prior repayment history with PayPal Credit products as well as other measures. We use delinquency status and trends to assist in making new and ongoing credit decisions, to adjust our models, to plan our collection practices and strategies and in our determination of our allowance for international consumer loans and interest receivable.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The following tables present the delinquency status of the principal amount of international consumer loans and interest receivable. The amounts shown below are based on the number of days past the billing date to the consumer. Current represents balances that are within 30 days of the billing date. Amounts as of March 31, 2018 and December 31, 2017 represent loans and interest receivable due from consumer accounts excluding amounts classified as held for sale, of which approximately 95.3% and 96.0%, respectively, were current.
March 31, 2018
(In millions)
Current
 
30 - 59 Days Past Due
 
60 - 89 Days Past Due
 
90 - 180 Days Past Due
 
Total Past Due
 
Total
$
384

 
$
10

 
$
3

 
$
6

 
$
19

 
$
403


December 31, 2017
(In millions)
Current
 
30 - 59 Days Past Due
 
60 - 89 Days Past Due
 
90 - 180 Days Past Due
 
Total Past Due
 
Total
$
313

 
$
7

 
$
2

 
$
4

 
$
13

 
$
326


We charge off consumer loan receivable balances in the month in which a customer balance becomes 180 days past the payment due date. Bankrupt accounts are charged off within 60 days after receipt of notification of bankruptcy. Loans receivable past the payment due date continue to accrue interest until they are charged off. We record an allowance for loss against the interest and fees receivable.

The following table summarizes the activity in the allowance for consumer loans and interest receivable for the three months ended March 31, 2018 and 2017:
 
March 31, 2018
 
March 31, 2017(1)
 
Consumer Loans Receivable
Interest Receivable
Total Allowance(2)
  
Consumer Loans Receivable
Interest Receivable
Total Allowance
 
(In millions)
Beginning balance
$
57

$
6

$
63

 
$
265

$
40

$
305

Provisions
23

3

26

 
120

29

149

Charge-offs
(39
)
(3
)
(42
)
 
(104
)
(32
)
(136
)
Recoveries
—

—

—

 
10

—

10

Ending balance
$
41

$
6

$
47

 
$
291

$
37

$
328

(1) Includes allowance related to loans and interest receivable, held for sale portfolio prior to its designation as held for sale.
(2) Beginning and ending balances include approximately $50 million and $31 million, respectively, of U.S. consumer receivables not designated as held for sale that are fully reserved and are expected to be charged off.

The tables above exclude receivables from other consumer credit products of $57 million and $55 million at March 31, 2018 and December 31, 2017, respectively, and allowances of $9 million and $7 million at March 31, 2018 and December 31, 2017, respectively.

The provision for loan losses relating to our international consumer loans receivable portfolio is recognized in transaction and loan losses. The provision for interest receivable due to interest and fees earned on our international consumer loans receivable portfolio is recognized in net revenues from other value added services as a reduction in revenue.

Merchant Receivables

We offer business financing solutions to certain existing small and medium-sized merchants through our PayPal Working Capital ("PPWC") product and, subsequent to our acquisition of Swift Capital ("Swift") in September 2017, through Swift business loan products. As of March 31, 2018 and December 31, 2017, the total outstanding balance in our pool of merchant loans, advances, interest and fees receivable was $1.2 billion and $1.0 billion, respectively, net of the participation interest sold to an independent chartered financial institution of $28 million and $28 million, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Through our PPWC product, merchants can borrow a certain percentage of their annual payment volume processed by PayPal and are charged a fixed fee for the loan or advance, which targets an annual percentage rate based on the overall credit assessment of the merchant. Loans and advances are repaid through a fixed percentage of the merchant's future payment volume that PayPal processes. Through our Swift business loan products, we provide merchants with access to short-term business financing based on an evaluation of both the applying business as well as the business owner. Swift business loans are collected by periodic payments until the balance has been satisfied.

The interest or fee is fixed at the time the loan or advance is extended and recognized as deferred revenues included in other current liabilities in our condensed consolidated balance sheet. The fixed interest or fee is amortized to net revenues from other value added services based on the amount repaid over the repayment period. We estimate the repayment period based on the merchant's payment processing history with PayPal, where available. For PPWC product, there is a general requirement that at least 10% of the original amount of the loan or advance plus the fixed fee must be repaid every 90 days. We calculate the repayment rate of the merchant's future payment volume so that repayment of the loan or advance and fixed fee is expected to generally occur within 9 to 12 months from the date of the loan or advance. On a monthly basis, we recalculate the repayment period based on the repayment activity on the receivable. As such, actual repayment periods are dependent on actual merchant payment processing volumes. For Swift business loans, we receive fixed periodic payments over the contractual term of the loan which generally ranges from 3 to 12 months. We actively monitor receivables with repayment periods greater than the original expected or contractual repayment period.

We closely monitor credit quality for our merchant loans and advances that we extend or purchase so that we can evaluate, quantify, and manage our credit risk exposure. To assess a merchant seeking a business financing loan or advance, we use, among other indicators, risk models developed internally which utilize information obtained from multiple data sources, both external and internal data to predict the likelihood of timely and satisfactory repayment by the merchant of the loan or advance amount and the related interest or fixed fee. Primary drivers of the models include the merchant's annual payment volume, payment processing history with PayPal and prior repayment history with the PayPal products where available, elements sourced from consumer credit bureau and business credit bureau reports, and other information obtained during the application process. We use delinquency status and trends to assist in making ongoing credit decisions, to adjust our internal models, to plan our collection practices and strategies and in our determination of our allowance for these loans and advances.

Merchant Receivables Delinquency and Allowance

The following tables present our estimate of the principal amount of merchant loans, advances, interest and fees receivable past their original expected or contractual repayment period.
March 31, 2018
(In millions)
Within Original Expected Repayment Period
 
30 - 59 Days Greater
 
60 - 89 Days Greater
 
90 - 180 Days Greater
 
180+ Days
 
Total Past Original Expected Repayment Period
 
Total
$
1,105

 
$
44

 
$
28

 
$
40

 
$
10

 
$
122

 
$
1,227

December 31, 2017
(In millions)
Within Original Expected Repayment Period
 
30 - 59 Days Greater
 
60 - 89 Days Greater
 
90 - 180 Days Greater
 
180+ Days
 
Total Past Original Expected Repayment Period
 
Total
$
884

 
$
44

 
$
28

 
$
43

 
$
13

 
$
128

 
$
1,012



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table summarizes the activity in the allowance for merchant loans and advances, interest and fees receivable, for the three months ended March 31, 2018 and 2017:
 
March 31, 2018
 
March 31, 2017
 
Merchant Loans and Advances
Interest and Fees Receivable
Total Allowance
  
Merchant Loans and Advances
Interest and Fees Receivable
Total Allowance
 
(In millions)
Beginning balance
$
52

$
7

$
59

 
$
28

$
3

$
31

Provisions
39

6

45

 
9

2

11

Charge-offs
(21
)
(2
)
(23
)
 
(10
)
(2
)
(12
)
Recoveries
2

—

2

 
2

—

2

Ending balance
$
72

$
11

$
83

 
$
29

$
3

$
32


For merchant loans and advances, the determination of delinquency, from current to 180 days past due, is based on the current expected or contractual repayment period of the loan or advance and fixed interest or fee payment as compared to the original expected or contractual repayment period. For Swift business loans, we charge off the receivable when the repayments are 180 days past due. For PPWC product, we charge off the receivable when the repayments are 180 days past our expectation of repayments and the merchant has not made a payment in the last 60 days or when the repayments are 360 days past due regardless of whether or not the merchant has made a payment within the last 60 days. Bankrupt accounts are charged off within 60 days of receiving notification of bankruptcy. The provision for loan losses is recognized in transaction and loan losses, and the provisions for interest and fees receivable is recognized in deferred revenues included in other current liabilities in our condensed consolidated balance sheet. Charge-offs that are recovered are recorded as a reduction to our allowance for loans and interest receivable.

Note 12—Notes Payable

In the fourth quarter of 2017, we entered into a credit agreement ("2017 Credit Agreement") that provides for an unsecured $3.0 billion, 364-day delayed-draw term loan credit facility, which is available in up to three borrowings. Borrowings and other amounts payable under the 2017 Credit Agreement are guaranteed by PayPal, Inc. Subject to specified conditions, we may designate one or more of our subsidiaries as additional borrowers under the 2017 Credit Agreement provided that we and PayPal, Inc. guarantee all borrowings and other obligations of any such subsidiaries under the 2017 Credit Agreement. As of March 31, 2018, no subsidiaries were designated as additional borrowers. Funds borrowed under the 2017 Credit Agreement may be used for capital allocation and other general corporate purposes. During the three months ended March 31, 2018, we effected two drawdowns aggregating to $2.0 billion under the 2017 Credit Agreement. As of March 31, 2018, $3.0 billion was outstanding under the 2017 Credit Agreement at a weighted average interest rate of 2.88%. Accordingly, at March 31, 2018, no borrowing capacity was available under the 2017 Credit Agreement. The total interest expense and fees we recorded related to this credit facility was approximately $15 million for the three months ended March 31, 2018. On April 5, 2018, we repaid $1.0 billion of the borrowings outstanding under the 2017 Credit Agreement. No remaining borrowing capacity is available under this agreement.

We maintain uncommitted credit facilities in various regions throughout the world, aggregating to approximately $350 million of borrowing capacity. Interest rate terms for these facilities vary by region and reflect prevailing market rates for companies with strong credit ratings. As of March 31, 2018, no amounts were outstanding under those facilities, and therefore, approximately $350 million of borrowing capacity was available, subject to customary conditions to borrowing.

In the third quarter of 2015, we entered into a credit agreement ("2015 Credit Agreement") that provides for an unsecured $2.0 billion, five-year revolving credit facility that includes a $150 million letter of credit sub-facility and a $150 million swingline sub-facility, with available borrowings under the revolving credit facility reduced by the amount of any letters of credit and swingline borrowings outstanding. Borrowings and other amounts payable under the 2015 Credit Agreement are guaranteed by PayPal, Inc. We may also, subject to the agreement of the applicable lenders, increase the commitments under the revolving credit facility by up to $500 million. Loans under the 2015 Credit Agreement will bear interest at either (i) London Interbank Offered Rate ("LIBOR") plus a margin (based on our public debt ratings) ranging from 1.00 percent to 1.625 percent or (ii) a formula based on the agent bank’s prime rate, the federal funds effective rate or LIBOR plus a margin (based on our public debt ratings) ranging from zero percent to 0.625 percent. Subject to specified conditions, we may designate one or more of our subsidiaries as additional borrowers under the 2015 Credit Agreement provided that we and PayPal, Inc. guarantee all borrowings and other obligations of any such

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

subsidiaries under the 2015 Credit Agreement. As of March 31, 2018, no subsidiaries were designated as additional borrowers. Funds borrowed under the 2015 Credit Agreement may be used for working capital, capital expenditures, acquisitions and other general corporate purposes. As of March 31, 2018, no borrowings or letters of credit were outstanding under the 2015 Credit Agreement. Accordingly, at March 31, 2018, $2.0 billion of borrowing capacity was available for the purposes permitted by the 2015 Credit Agreement, subject to customary conditions to borrowing.

Note 13—Commitments and Contingencies

Commitments

As of March 31, 2018 and December 31, 2017, approximately $27.3 billion and $26.4 billion, respectively, of unused credit was available to PayPal Credit account holders. While this amount represents the total unused credit available, we have not experienced, and do not anticipate, that all of our PayPal Credit account holders will access their entire available credit at any given point in time. In addition, the individual lines of credit that make up this unused credit are subject to periodic review and termination by the chartered financial institution that is the issuer of PayPal Credit products based on, among other things, account usage and customer creditworthiness. When a consumer funds a purchase in the U.S. using a PayPal Credit product issued by a chartered financial institution, the chartered financial institution extends credit to the consumer, funds the extension of credit at the point of sale and advances funds to the merchant. We subsequently purchase the receivables related to the consumer loans extended by the chartered financial institution and, as a result of such purchase, bear the risk of loss in the event of loan defaults. Although the chartered financial institution continues to own each customer account, we own the related receivable (excluding participation interests sold) and are responsible for all servicing functions related to the account.

Litigation and Regulatory Matters

Overview

We are involved in legal and regulatory proceedings on an ongoing basis. Many of these proceedings are in early stages, and may seek an indeterminate amount of damages. If we believe that a loss arising from such matters is probable and can be reasonably estimated, we accrue the estimated liability in our financial statements. If only a range of estimated losses can be determined, we accrue an amount within the range that, in our judgment, reflects the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, we accrue the low end of the range. For those proceedings in which an unfavorable outcome is reasonably possible but not probable, we have disclosed an estimate of the reasonably possible loss or range of losses or we have concluded that an estimate of the reasonably possible loss or range of losses arising directly from the proceeding (i.e., monetary damages or amounts paid in judgment or settlement) are not material. If we cannot estimate the probable or reasonably possible loss or range of losses arising from a legal proceeding, we have disclosed that fact. In assessing the materiality of a legal proceeding, we evaluate, among other factors, the amount of monetary damages claimed, as well as the potential impact of non-monetary remedies sought by plaintiffs (e.g., injunctive relief) that may require us to change our business practices in a manner that could have a material adverse impact on our business. With respect to the matters disclosed in this Note 13, we are unable to estimate the possible loss or range of losses that could potentially result from the application of such non-monetary remedies.

Amounts accrued for legal and regulatory proceedings for which we believe a loss is probable were not material for the three months ended March 31, 2018. Except as otherwise noted for the proceedings described in this Note 13, we have concluded, based on currently available information, that reasonably possible losses arising directly from the proceedings (i.e., monetary damages or amounts paid in judgment or settlement) in excess of our recorded accruals are also not material. However, legal and regulatory proceedings are inherently unpredictable and subject to significant uncertainties. If one or more matters were resolved against us in a reporting period for amounts in excess of management’s expectations, the impact on our operating results or financial condition for that reporting period could be material.

Regulatory Proceedings

We are required to comply with U.S. economic and trade sanctions administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”). We have self-reported to OFAC certain transactions that were inadvertently processed but subsequently identified as possible violations of U.S. economic and trade sanctions. In March 2015, we reached a settlement with

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(Unaudited)

OFAC regarding possible violations arising from our sanctions compliance practices between 2009 and 2013, prior to the implementation of our real-time transaction scanning program. Subsequently, we have self-reported additional transactions as possible violations, and we have received new subpoenas from OFAC seeking additional information about certain of these transactions. Such self-reported transactions could result in claims or actions against us, including litigation, injunctions, damage awards, fines or penalties, or require us to change our business practices in a manner that could result in a material loss, require significant management time, result in the diversion of significant operational resources or otherwise harm our business.

On March 28, 2016, we received a Civil Investigative Demand (“CID”) from the Federal Trade Commission (“FTC”) as part of its investigation to determine whether we, through our Venmo service, have been or are engaged in deceptive or unfair practices in violation of the Federal Trade Commission Act. The CID requested the production of documents and answers to written questions related to our Venmo service. We have cooperated with the FTC in connection with the CID. On February 27, 2018, we entered into a Consent Order with the FTC in which we settled potential allegations arising from our Venmo services between 2013 and 2017. The Consent Order does not contain a monetary penalty, but requires PayPal to make various changes to Venmo’s disclosures and business practices. The Consent Order was subject to public comment through March 29, 2018 and is subject to final approval by the FTC. As required by the Consent Order, we will cooperate with the FTC’s requirements and work to ensure compliance with the Consent Order. Any failure to comply with the Consent Order may increase the possibility of additional adverse consequences, including litigation, additional regulatory actions, injunctions, or monetary penalties, or require further changes to our business practices, significant management time, or the diversion of significant operational resources, all of which could result in a material loss or otherwise harm our business.

Legal Proceedings

On January 12, 2017, a putative shareholder derivative action captioned Silverman v. Schulman, et al., Case No. 5:17-cv-00162 (the “California Derivative Case”) was filed in the U.S. District Court for the Northern District of California (the "Court"). On March 24, 2017, a second derivative action substantially similar to the California Derivative Case captioned Seeman v. Schulman, et al., Case No. 1:17-cv-00318-UNA, was filed in the U.S. District Court for the District of Delaware (the “Delaware Derivative Case”). On April 19, 2017, the Delaware court in the Delaware Derivative Case issued an order adopting a stipulation filed by the parties transferring the Delaware Derivative Case to the Court so that the Delaware Derivative Case could be consolidated with the pending California Derivative Case. On April 27 and 28, 2017, two additional shareholder derivative lawsuits substantially similar to the California Derivative Case and Delaware Derivative Case were filed in the Court. These cases are captioned Sims v. Schulman, et al., Case No. 1:17-cv-02428, and Liss v. Schulman, et al., Case No. 1:17-cv-02446-NC (together with the California Derivative Case and the Delaware Derivative Case, the “Derivative Cases”). The Derivative Cases are purportedly brought on behalf of the Company and assert claims relating to our disclosure in our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2016, that on March 28, 2016, we received a CID from the FTC as part of its investigation to determine whether we, through our Venmo service, have been or are engaged in deceptive or unfair practices in violation of the Federal Trade Commission Act. The Derivative Cases allege that the Company’s Chief Executive Officer, Chief Financial Officer, former interim Chief Financial Officer, and certain members of its Board of Directors breached their fiduciary duties to the Company, violated Section 14(a) of the Exchange Act, and were unjustly enriched by, among other things, causing or permitting the Company to issue materially false and misleading statements or omissions regarding the Company’s compliance with applicable laws and regulations with respect to its Venmo service, and/or by permitting or causing the Company to engage in unfair trade practices through its Venmo service. The Derivative Cases seek, among other things, to recover unspecified compensatory damages on behalf of the Company arising out of the individual defendants’ alleged wrongful conduct. Although plaintiffs in the Derivative Cases do not seek relief against the Company, we have certain indemnification obligations to the individual defendants. On June 30, 2017, the Court issued an order approving a stipulation filed by the parties in the Derivative Cases that consolidates these cases and appoints co-lead plaintiffs’ counsel for the consolidated case, captioned In re PayPal Holdings, Inc. Shareholder Derivative Litigation, Lead Case No. 5:17-cv-00162-RS (the “Consolidated Derivative Case”). The Court’s order states that it applies to each purported derivative action that is subsequently filed in, removed to, or transferred to the Court, arising out of the same or substantially the same transactions or events as the Derivative Cases. On July 31, 2017, plaintiffs’ counsel designated the complaint filed in the Liss action as the operative complaint for the Consolidated Derivative Case. On October 5, 2017, another putative shareholder derivative suit was filed in the Court captioned Iron Workers Local No. 25 Pension Fund v. John J. Donahoe, et al., Case No. 5:17-cv-05741-NC, that makes similar allegations and advances similar claims against the same defendants as those at issue in the Consolidated Derivative Case. Pursuant to the Court’s consolidation order, this shareholder derivative suit is part of the Consolidated Derivative Case. On September 28, 2017, we filed a motion to dismiss the operative complaint on grounds that plaintiffs lack standing to pursue claims on behalf of the Company because they did not make a pre-suit demand on the Company’s Board of Directors prior to filing the Derivative Cases and failed to establish that making such a demand would have been futile. On January 18, 2018, the Court granted our motion to dismiss with leave to amend and gave plaintiffs 30 days from that date to file an amended

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(Unaudited)

complaint. On February 16, 2018, plaintiffs in the Consolidated Derivative Case filed an amended complaint. Plaintiffs’ counsel also sent a letter dated February 15, 2018 to counsel for the defendants that purports to be a litigation demand on the Company's Board of Directors. In April 2018, defendants in the Consolidated Derivative Case entered into a tolling agreement that tolls the running of any statute of limitations applicable to the claims at issue in the lawsuit and the litigation demand plaintiffs sent to the Company's Board of Directors until 30 days from the time the Board issues a final response to the demand or three years elapse from the date of the tolling agreement, whichever comes first. Pursuant to the agreement, plaintiffs in the Consolidated Derivative Case have agreed to voluntarily dismiss the lawsuit without prejudice for now.

We have received subpoenas from the U.S. Department of Justice (“DOJ”) seeking the production of certain information related to our historical anti-money laundering program. We are cooperating with the DOJ in providing information in response to the subpoenas. We are unable to predict the outcome of the government's investigation.
In November 2017, we announced that we had suspended the operations of TIO Networks (“TIO”) as part of an ongoing investigation of security vulnerabilities of the TIO platform. On December 1, 2017 we announced that we had identified evidence of unauthorized access to TIO’s network, including locations that stored personal information of some of TIO’s customers and customers of TIO billers and the potential compromise of personally identifiable information for approximately 1.6 million customers. We have received a number of governmental inquiries, including from state attorneys general, and we may be subject to additional governmental inquiries and investigations in the future. In addition, on December 6, 2017, a putative class action lawsuit captioned Sgarlata v. PayPal Holdings, Inc., et al., Case No. 3:17-cv-06956 was filed in the Court against the Company, its Chief Executive Officer, its Chief Financial Officer and Hamed Shahbazi, the former chief executive officer of TIO (the “Defendants”) alleging violations of federal securities laws. Specifically, the lawsuit alleges that Defendants made false or misleading statements or failed to disclose that TIO’s data security program was inadequate to safeguard the personally identifiable information of its users, those vulnerabilities threatened continued operation of TIO’s platform, the Company’s revenues derived from TIO services were thus unsustainable, and consequently, the Company overstated the benefits of the TIO acquisition, and, as a result, the Company’s public statements were materially false and misleading at all relevant times. The plaintiff who initiated the lawsuit sought to represent a class of shareholders who acquired shares of the Company’s common stock between February 14, 2017 through December 1, 2017 and sought damages and attorneys’ fees, among other relief. On March 16, 2018, the Court appointed two new plaintiffs, not the original plaintiff who filed the case, as interim co-lead plaintiffs in the case and appointed two law firms as interim co-lead counsel. Pursuant to stipulations entered into by the parties to the case, the Court issued orders on March 30 and April 6, 2018 providing for the publication by interim co-lead counsel of an amended notice under the Private Securities Litigation Reform Act given the anticipated amendment of the complaint to include an amended class definition that includes individuals who purchased options to purchase our common stock between February 14, 2017 through December 1, 2017, the filing of an amended complaint by co-lead plaintiffs within seventy-five days of the March 30, 2018 order, and a briefing schedule on the Defendants’ anticipated motions to dismiss the amended complaint. We may be subject to additional litigation relating to TIO’s data security platform or the suspension of TIO’s operations in the future.

General Matters
Other third parties have from time to time claimed, and others may claim in the future, that we have infringed their intellectual property rights. We are subject to patent disputes, and expect that we will increasingly be subject to additional patent infringement claims involving various aspects of our business as our products and services continue to expand in scope and complexity. Such claims may be brought directly or indirectly against our companies and/or against our customers (who may be entitled to contractual indemnification under their contracts with us), and we are subject to increased exposure to such claims as a result of our acquisitions, particularly in cases where we are entering into new lines of business in connection with such acquisitions. We have in the past been forced to litigate such claims, and we believe that additional lawsuits alleging such claims will be filed against us. Intellectual property claims, whether meritorious or not, are time consuming and costly to defend and resolve, could require expensive changes in our methods of doing business or could require us to enter into costly royalty or licensing agreements on unfavorable terms or make substantial payments to settle claims or to satisfy damages awarded by courts.
From time to time, we are involved in other disputes or regulatory inquiries that arise in the ordinary course of business, including suits by our customers (individually or as class actions) alleging, among other things, improper disclosure of our prices, rules or policies, that our practices, prices, rules, policies or customer/user agreements violate applicable law or that we have acted unfairly and/or not acted in conformity with such prices, rules, policies or agreements. In addition to these types of disputes and regulatory inquiries, our operations are also subject to regulatory and/or legal review and/or challenges that tend to reflect the increasing global regulatory focus to which the payments industry is subject and, when taken as a whole with other regulatory and legislative action, such actions could result in the imposition of costly new compliance burdens on our business and customers and may lead

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(Unaudited)

to increased costs and decreased transaction volume and revenue. Further, the number and significance of these disputes and inquiries are increasing as we have grown larger, our business has expanded in scope (both in terms of the range of products and services that we offer and our geographical operations) and our products and services have increased in complexity. Any claims or regulatory actions against us, whether meritorious or not, could be time consuming, result in costly litigation, settlement payments, damage awards (including statutory damages for certain causes of action in certain jurisdictions), fines, penalties, injunctive relief or increased costs of doing business through adverse judgment or settlement, require us to change our business practices in expensive ways, require significant amounts of management time, result in the diversion of significant operational resources or otherwise harm our business.

Indemnification Provisions
We entered into a separation and distribution agreement, a tax matters agreement, an operating agreement and various other agreements with eBay to govern the separation and relationship of the two companies going forward. These agreements provide for specific indemnity and liability obligations and could lead to disputes between us and eBay, which may be significant. In addition, the indemnity rights we have against eBay under the agreements may not be sufficient to protect us, and our indemnity obligations to eBay may be significant.
In the ordinary course of business, we include limited indemnification provisions in certain of our agreements with parties with whom we have commercial relationships, including our standard marketing, promotions, and application-programming-interface license (API) agreements. Under these contracts, we generally indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with claims by any third party with respect to our domain names, trademarks, logos, and other branding elements to the extent that such marks are related to the subject agreement. In a limited number of agreements, we have provided an indemnity for other types of third-party claims, which are indemnities mainly related to intellectual property rights. We have also provided an indemnity to our payments processors in the event of certain third-party claims or card association fines against the processor arising out of conduct by us or our customers. It is not possible to determine the maximum potential loss under these indemnification provisions due to our limited history of prior indemnification claims and the unique facts and circumstances involved in each particular situation. To date, no significant costs have been incurred, either individually or collectively, in connection with our indemnification provisions.

Off-Balance Sheet Arrangements

As of March 31, 2018 and December 31, 2017, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.

Protection Programs

We provide merchants and consumers with protection programs on substantially all transactions completed through our Payments Platform, except for transactions using our gateway products. These programs protect both merchants and consumers from loss primarily due to fraud and counterparty performance. Our Buyer Protection Program provides protection to consumers for qualifying purchases by reimbursing the consumer for the full amount of the purchase if a purchased item does not arrive or does not match the seller’s description. Our Seller Protection Programs provide protection to merchants against claims that a transaction was not authorized by the buyer or claims that an item was not received by covering the seller for the full amount of the payment on eligible sales.

The maximum potential exposure under our protection programs is estimated to be the portion of total eligible transaction volume (TPV) for which buyer or seller protection claims may be raised under our existing user agreements. Since eligible transactions are typically completed in a period significantly shorter than the period under which disputes may be opened, and based on our historical losses to date, we do not believe that the maximum potential exposure is representative of our actual potential exposure. The actual amount of potential exposure cannot be quantified as we are unable to determine total eligible transactions where performance by a merchant or customer is incomplete or completed transactions that may result in a claim under our protection programs. We record a liability with respect to losses under these protection programs when they are probable and the amount can be reasonably estimated.


29
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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table provides management's estimate of the maximum potential exposure related to our protection programs as of March 31, 2018 and December 31, 2017:
 
March 31, 2018
  
December 31, 2017
 
(In millions)
Maximum potential exposure
$
173,764

 
$
165,207


The following table provides the amount of allowance for transaction losses and negative customer balances related to our protection programs as of March 31, 2018 and December 31, 2017:
 
March 31, 2018
  
December 31, 2017
 
(In millions)
Allowance for transaction losses and negative customer balances
$
283

 
$
266


Note 14—Related Party Transactions

As of March 31, 2018 and December 31, 2017, there were no material amounts payable to or amounts receivable from related parties. For all periods presented, there were no material related party transactions.

Note 15—Stock Repurchase Programs

In April 2017, our Board of Directors authorized a stock repurchase program that provides for the repurchase of up to $5 billion of our common stock, with no expiration from the date of authorization. The stock repurchase program is intended to offset the impact of dilution from our equity compensation programs and, subject to market conditions and other factors, may also be used to make opportunistic repurchases of our common stock to reduce outstanding share count. Any share repurchases under our stock repurchase program may be made through open market transactions, block trades, privately negotiated transactions including accelerated share repurchase agreements or other means at times and in such amounts as management deems appropriate and will be funded from our working capital or other financing alternatives. However, any stock repurchases are subject to market conditions and other uncertainties and we cannot predict if or when any stock repurchases will be made. Moreover, we may terminate our stock repurchase program at any time without notice.

In February 2018, we entered into an accelerated share repurchase ("ASR") agreement with an unrelated third party financial institution to repurchase shares of our common stock. Under the terms of the ASR agreement, we made an upfront payment of approximately $1.0 billion to the third party financial institution and received approximately 12.8 million shares of our common stock during the term of the transaction, which ended in March 2018. The total number of shares of our common stock repurchased was based on the volume-weighted average share price of our common stock during the term of the transaction, less a discount and subject to adjustments pursuant to the terms of the applicable ASR agreement.

We recorded the initial payment of $1.0 billion as a reduction to stockholders' equity on our condensed consolidated balance sheet. All common stock received was recorded as treasury stock and the forward contract indexed to our own common stock met all applicable criteria for equity classification.


30
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PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The stock repurchase activity under the April 2017 stock repurchase program during the three months ended March 31, 2018 is summarized as follows:
 
Shares Repurchased
 
Average Price
Paid per Share(1) (2)
 
Cash Paid for Shares Repurchased
 
Remaining Amount Authorized
 
(In millions, except per share amounts)
Balance as of January 1, 2018
 
 
 
 
 
 
$
4,999

Repurchases of shares of common stock in the open market
10.8

 
$
76.82

 
825

 
4,174

Repurchases of shares of common stock under the ASR agreement
12.8

 
$
78.03

 
1,000

 
3,174

Balance as of March 31, 2018
23.6

 
 
 
$
1,825

 
$
3,174

(1)Average price paid per share for open market purchases includes broker commissions.
(2) Average price paid per share under the ASR agreement represents the volume-weighted average share price, less a discount and adjustments pursuant to the terms of the agreement. Treasury stock recorded for repurchases under the ASR agreement amounts to $985 million.

These repurchased shares of common stock were recorded as treasury stock for purposes of calculating earnings per share, and were accounted for under the cost method. No repurchased shares of common stock have been retired.

Note 16—Stock-Based Plans

Stock Options

As of March 31, 2018, 1.9 million options to purchase shares of common stock were outstanding. No new options were granted in the three months ended March 31, 2018.

Restricted Stock Units (RSUs) and Performance-Based Restricted Stock Units (PBRSUs)

The following table summarizes the RSU and PBRSU activity under our equity incentive plans for the three months ended March 31, 2018:
 
Units 
 
(In thousands)
Outstanding at January 1, 2018
33,875

Awarded(1)
12,103

Vested(1)
(9,663
)
Forfeited
(484
)
Outstanding at March 31, 2018
35,831

Expected to vest
30,871

(1) Includes approximately 2.1 million additional PBRSUs issued due to company performance in connection with the Company's 2017 annual incentive plan.

The weighted average grant-date fair value of RSUs and PBRSUs granted during the three months ended March 31, 2018 was $78.58 per share.

In the three months ended March 31, 2018, the Company granted RSUs that vest in equal annual installments over a three-year period, 1.5 million PBRSUs with a one-year performance period (fiscal 2018) and cliff vesting following the completion of the performance period in February 2019 (one year from the annual incentive award cycle grant date) and 0.7 million PBRSUs with a three-year performance period. Over the respective performance period, the number of PBRSUs that may be issued and the related stock-based compensation expense that is recognized is adjusted upward or downward based upon the probability of achieving the approved performance targets against the performance metrics. Depending on the probability of achieving the pre-established performance targets, the PBRSUs issued could range from 0% to 200% of the target amount.

31
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Stock-based Compensation Expense

We record stock-based compensation expense for our equity incentive plans in accordance with the provisions of the authoritative accounting guidance, which requires the measurement and recognition of compensation expense based on estimated fair values.

The impact on our results of operations of recording stock-based compensation expense under our equity incentive plans for the three months ended March 31, 2018 and 2017 was as follows:
 
Three Months Ended March 31,
 
2018
 
2017
 
(In millions)
Customer support and operations
$
38

 
$
30

Sales and marketing
44

 
28

Product development
64

 
45

General and administrative
59

 
42

Depreciation and amortization
4

 
2

Total stock-based compensation expense
$
209

 
$
147

Capitalized as part of internal use software and website development costs
$
7

 
$
3


Note 17—Income Taxes

Our effective tax rate for the three months ended March 31, 2018 and 2017 was 7% and 12%, respectively. The difference between our effective tax rate for the three months ended March 31, 2018 and the U.S. federal statutory rate of 21% was primarily the result of foreign income taxed at different rates and discrete tax benefits related to stock-based compensation. The difference between our effective tax rate for the three months ended March 31, 2017 and the U.S. federal statutory rate of 35% was primarily the result of foreign income taxed at different rates.

During the three months ended March 31, 2018, we recognized tax expense adjustments of $3 million to the provisional amounts recorded at December 31, 2017 for the enactment-date effects of the Tax Act. All amounts recorded related to the enactment-date effects of the Tax Act as of March 31, 2018 are considered provisional estimates because we have not completed our accounting for certain elements of the Tax Act, including whether taxes due on future U.S. inclusions related to Global Intangible Low Taxed Income ("GILTI") are recorded as a current-period expense when incurred or whether such amounts should be factored into our measurement of its deferred taxes. As a result, for the period ended March 31, 2018, we have treated GILTI as a period cost. We will continue to refine our calculations as additional analysis is completed. Our provisional estimates may be affected as we gain a more thorough understanding of the Tax Act and any such changes to those estimates could be material to income tax expense.


Note 18—Restructuring

During the first quarter of 2018 and 2017, management approved strategic reductions of the existing global workforce, which resulted in restructuring charges of $25 million and $40 million, respectively. The reduction approved in the first quarter of 2018 also includes restructuring charges related to the decision to wind down TIO's operations. The reduction and timing of cash payments associated with the 2018 restructuring are expected to be substantially completed by the end of 2018. We incurred employee and severance benefits expenses under the 2017 strategic reduction, which was substantially completed by the end of the year.


32
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table summarizes the restructuring reserve activity during the three months ended March 31, 2018:
 
Employee Severance and Benefits
 
(In millions)
Accrued liability as of January 1, 2018
$
2

Charges
25

Payments
(2
)
Accrued liability as of March 31, 2018
$
25



Note 19—Accumulated Other Comprehensive Income (Loss)

The following table summarizes the changes in accumulated balances of other comprehensive income (loss) for the three months ended March 31, 2018:
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
Unrealized Gains (Losses) on Investments
 
Foreign
Currency
Translation
 
Estimated tax benefit
 
Total
 
(In millions)
Beginning balance
$
(111
)
 
$
(12
)
 
$
(25
)
 
$
6

 
$
(142
)
Other comprehensive income (loss) before reclassifications
(62
)
 
(16
)
 
2

 
4

 
(72
)
Less: Amount of gains (losses) reclassified from accumulated other comprehensive income
(44
)
 
(1
)
 
—

 
—

 
(45
)
Net current period other comprehensive income (loss)
(18
)
 
(15
)
 
2

 
4

 
(27
)
Ending balance
$
(129
)
 
$
(27
)
 
$
(23
)
 
$
10

 
$
(169
)

The following table summarizes the changes in accumulated balances of other comprehensive income (loss) for the three months ended March 31, 2017:
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
Unrealized Gains (Losses) on Investments
 
Foreign
Currency
Translation
 
Estimated tax benefit
 
Total
 
(In millions)
Beginning balance
$
131

 
$
(5
)
 
$
(68
)
 
$
1

 
$
59

Other comprehensive income (loss) before reclassifications
(32
)
 
—

 
13

 
1

 
(18
)
Less: Amount of gains (losses) reclassified from accumulated other comprehensive income
40

 
(1
)
 
—

 
—

 
39

Net current period other comprehensive income (loss)
(72
)
 
1

 
13

 
1

 
(57
)
Ending balance
$
59

 
$
(4
)
 
$
(55
)
 
$
2

 
$
2


33
Table of Contents
PayPal Holdings, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table provides details about reclassifications out of accumulated other comprehensive income (loss) for the three months ended March 31, 2018 and 2017:
Details about Accumulated Other Comprehensive
Income (Loss) Components
 
Amount of Gains (Losses) Reclassified from Accumulated Other Comprehensive Income (Loss)
 
Affected Line Item in the Statement of Income
 
 
Three Months Ended March 31,
 
 
 
 
2018
 
2017
 
 
 
 
(In millions)
 
 
Gains (losses) on cash flow hedges-foreign exchange contracts
 
$
(44
)
 
$
40

 
Net revenues
Unrealized gains (losses) on investments
 
(1
)
 
(1
)
 
Other income (expense), net
 
 
$
(45
)
 
$
39

 
Income before income taxes
 
 
—

 
—

 
Income tax expense
Total reclassifications for the period
 
$
(45
)
 
$
39

 
Net income








34
Table of Contents

Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements that involve expectations, plans or intentions (such as those relating to future business, future results of operations or financial condition, new or planned features or services, or management strategies). These forward-looking statements can be identified by words such as “may,” “will,” “would,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “intend,” “plan” and other similar expressions. These forward-looking statements involve risks and uncertainties that could cause our actual results and financial condition to differ materially from those expressed or implied in our forward-looking statements. Such risks and uncertainties include, among others, those discussed in Part I, Item 1A, Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2017 (the "2017 Form 10-K"), as supplemented and, to the extent inconsistent, superseded (if applicable) by some of the information in the risk factors set forth below in Part II, Item 1A, Risk Factors, of this Form 10-Q, as well as in our unaudited condensed consolidated financial statements, related notes, and the other information appearing elsewhere in this report and our other filings with the Securities and Exchange Commission, or the SEC. We do not intend, and undertake no obligation, to update any of our forward-looking statements after the date of this report to reflect actual results or future events or circumstances. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes that appear elsewhere in this report. Unless otherwise expressly stated or the context otherwise requires, references to “we,” “our,” “us,” “the Company” and “PayPal” refer to PayPal Holdings, Inc. and its consolidated subsidiaries.

Business Environment

We are a leading technology platform and digital payments company that enables digital and mobile payments on behalf of consumers and merchants worldwide. Our vision is to democratize financial services, as we believe that managing and moving money is a right for all people, not just the affluent. Our goal is to increase our relevance for consumers and merchants to manage and move their money anywhere in the world, anytime, on any platform and using any device. We also facilitate person-to-person payments through our PayPal, Venmo and Xoom products. Our combined payment solutions, including our PayPal, PayPal Credit, Braintree, Venmo, and Xoom products, compose our proprietary Payments Platform.

We operate globally and in a rapidly evolving regulatory environment characterized by a heightened regulatory focus on all aspects of the payments industry. That focus continues to become even more heightened as regulators on a global basis focus on such important issues as countering terrorist financing, anti-money laundering, privacy and consumer protection. Some of the laws and regulations to which we are subject were enacted recently, and the laws and regulations applicable to us, including those enacted prior to the advent of digital and mobile payments, are continuing to evolve through legislative and regulatory action and judicial interpretation. Non-compliance with laws and regulations, increased penalties and enforcement actions related to non-compliance, changes in laws and regulations or their interpretation, and the enactment of new laws and regulations applicable to us could have a material adverse impact on our business, results of operations and financial condition.

The United Kingdom ("U.K.") held a referendum in June 2016 in which a majority of voters approved an exit from the European Union ("EU") (“Brexit”). In March 2017, the U.K. government gave formal notice of its intention to leave the EU and started the process of negotiating the future terms of the U.K.'s relationship with the EU. Brexit could adversely affect U.K., regional (including European) and worldwide economic and market conditions and could contribute to instability in global financial and foreign exchange markets, including volatility in the value of the British Pound and Euro.

We have foreign exchange exposure management programs designed to help reduce the impact from foreign currency rate movements. For both the three months ended March 31, 2018 and 2017, net revenues generated from our U.K. operations constituted 11% of total net revenues. During each of these periods, net revenues generated from the EU (excluding the U.K.) constituted less than 20% of total net revenues. For additional information on how Brexit could affect our business, see Part I, Item 1A, Risk Factors in our 2017 Form 10-K, as supplemented and, to the extent inconsistent, superseded below in Part II, Item 1A, Risk Factors in this Form 10-Q.

Information security risks for global payments and technology companies have significantly increased in recent years. Although we are not aware of any material impacts relating to cyberattacks or other information security breaches on our Payments Platform, we are not immune to these risks and there can be no assurance that we will not suffer such losses in the future.

35

Overview of Results of Operations

The following table provides a summary of our condensed consolidated GAAP financial measures for the three months ended March 31, 2018 and 2017:
 
Three Months Ended March 31,
 
Percent Increase/(Decrease)
 
2018
 
2017
 
 
(In millions, except percentages and per share data)
Net revenues
$
3,685

 
$
2,975

 
24
 %
Operating expenses
3,151

 
2,544

 
24
 %
Operating income
$
534

 
$
431

 
24
 %
Operating margin
14
%
 
14
%
 
**

Income tax expense
$
37

 
$
54

 
(31
)%
Effective tax rate
7
%
 
12
%
 
**

Net income
$
511

 
$
384

 
33
 %
Net income per diluted share
$
0.42

 
$
0.32

 
33
 %
Net cash provided by operating activities
$
(349
)
 
$
751

 
(146
)%
All amounts in tables are rounded to the nearest million, except as otherwise noted. As a result, certain amounts may not recalculate using the rounded amounts provided.
** Not meaningful

Three Months Ended March 31, 2018 and 2017

Net revenues increased $710 million, or 24%, in the three months ended March 31, 2018 compared to the same period of the prior year driven primarily by growth in TPV (as defined below under "Net revenues") of 32% compared to the same period of the prior year. Net revenues from our recent acquisition of Swift contributed one percentage point to the growth rate.

Total operating expenses increased $607 million, or 24%, in the three months ended March 31, 2018 compared to the same period of the prior year due primarily to increases in transaction expense, restructuring and other, general and administrative, sales and marketing and product development expenses. Operating expenses related to our recent acquisitions of TIO and Swift collectively contributed three percentage points to the growth rate in total operating expenses. In March 2018, our management decided to wind down TIO's operations.

Operating income increased $103 million, or 24%, in the three months ended March 31, 2018 compared to the same period of the prior year due to the increase in net revenues and positive impact of held for sale accounting for our U.S. consumer credit portfolio offset by the growth in operating expenses and impact of recent acquisitions. Our operating margin was 14% in both the three months ended March 31, 2018 and 2017. Operating margin for the three months ended March 31, 2018 was negatively impacted by growth in transaction expense which increased 29% in the three months ended March 31, 2018 compared to net revenues, which increased 24% in the same period. These impacts were offset by operating efficiencies in our business.

Net income increased by $127 million, or 33%, in the three months ended March 31, 2018 compared to the same period of the prior year due primarily to the increase in operating income of $103 million and a decrease in income tax expense of $17 million, which was driven by discrete tax benefits related to stock-based compensation partially offset by tax expense associated with the increase in operating income. For the three months ended March 31, 2018, our diluted net income per share was $0.42, a $0.10 increase compared to the same period of the prior year.



36


Non-GAAP Financial Measures

The following table provides a summary of our condensed consolidated non-GAAP financial measures for the three months ended March 31, 2018 and 2017:
 
Three Months Ended March 31,
 
Percent Increase/(Decrease)
 
2018
 
2017
 
 
(In millions, except percentages and per share data)
Non-GAAP operating income
$
829

 
$
643

 
29
 %
Non-GAAP operating margin
22
%
 
22
%
 
**

Non-GAAP income tax expense
$
151

 
$
116

 
30
 %
Non-GAAP net income
$
692

 
$
534

 
30
 %
Non-GAAP net income per diluted share
$
0.57

 
$
0.44

 
29
 %
Free cash flow
$
(527
)
 
$
603

 
(187
)%
All amounts in tables are rounded to the nearest millions, except as otherwise noted. As a result, certain amounts may not recalculate using the rounded amounts provided.
** Not meaningful

Non-GAAP operating income, non-GAAP operating margin, non-GAAP income tax expense, non-GAAP net income, non-GAAP net income per diluted share and free cash flow are not financial measures prepared in accordance with the U.S. GAAP. For information on how we compute these non-GAAP financial measures and a reconciliation to the most directly comparable financial measures prepared in accordance with GAAP, please refer to “Non-GAAP Financial Information” below.

Impact of Foreign Currency Exchange Rates
We have significant operations internationally that are denominated in foreign currencies, primarily the British Pound, Euro, Australian Dollar and Canadian Dollar, subjecting us to foreign currency risk which may adversely impact our financial results. The strengthening or weakening of the U.S. dollar versus the British Pound, Euro, Australian Dollar and Canadian Dollar, as well as other currencies in which we conduct our international operations, impacts the translation of our net revenues and expenses generated in these foreign currencies into the U.S. dollar. In the three months ended March 31, 2018 and 2017, we generated approximately 45% and 46% of our net revenues from customers domiciled outside of the United States ("U.S."), respectively. Other than the U.S., the U.K. was the only country where we generated more than 10% of total net revenues in the three months ended March 31, 2018 and 2017. During each of these periods, net revenues generated from the EU (excluding the U.K.) constituted less than 20% of total net revenues. Because we have generated substantial net revenues internationally in recent periods, including during the periods presented, we are subject to the risks of doing business in foreign countries. See Part I, Item 1A, Risk Factors in our 2017 Form 10-K, as supplemented and, to the extent inconsistent, superseded (if applicable) below in Part II, Item 1A, Risk Factors in this Form 10-Q.
We calculate the year-over-year impact of foreign currency movements on our business using prior period foreign currency exchange rates applied to current period transactional currency amounts. While changes in foreign currency exchange rates affect our reported results, we have a foreign currency exchange exposure management program whereby we designate certain foreign currency exchange contracts as cash flow hedges designed to reduce the impact on earnings from foreign currency exchange rate movements. Gains and losses from these foreign currency exchange contracts are recognized as a component of transaction revenues in the same period the forecasted transactions impact earnings.


37

In the three months ended March 31, 2018 and March 31, 2017, year-over-year foreign currency movements relative to the U.S. dollar had the following impact on our reported results:
 
Three Months Ended March 31, 2018
 
(In millions)
Favorable impact to net revenues (exclusive of hedging impact)
$
141

Hedging impact
(50
)
Favorable impact to net revenues
91

Unfavorable impact to operating expense
(59
)
Net impact to operating income
$
32