What eBay Gets from Its New Best Friend
PayPal brings a lot of strengths to eBay, but its hefty price tag means eBay will have to find the ROI—fast
By Peter Lucas
Sometimes it makes more sense to acquire the competition than to continue waging an expensive battle to defeat it. That was the conclusion San Jose, Calif.-based eBay Inc. reached in July when it announced its intent to purchase PayPal Inc. for about $1.5 billion.
The acquisition, which is expected to be completed by year’s end, closes the
book on an unsuccessful, multi-million dollar campaign begun by eBay in 1999
to make its eBay Payments By Billpoint service the leading payment mechanism
on its site.
Although the Billpoint experiment proved a costly mistake—analysts estimate eBay had invested more than $250 million in Billpoint—the decision to acquire PayPal for about 25% more than its market valuation as of July 5 is not the equivalent of waving a white flag, analysts say. Quite the contrary; many view eBay’s acquisition of PayPal, which is the preferred online payment mechanism on eBay, as a shrewd tactic expected to achieve three goals: significantly increase eBay’s revenues by reducing its transaction processing costs, boost volume over its site and expand eBay’s e-commerce presence on the web, which will increase earnings from user fees.
Furthermore, PayPal is not your typical highflying dot-com. Since going public in February it has turned a profit, a rare distinction for dot-coms with management teams in their twenties and early thirties. Net income in the second quarter totaled $529,000 after a $1.2 million profit in the first quarter, reversing losses of $27.7 million and $29.3 million for the same periods a year earlier.
Rescuing a failed strategy
PayPal has also demonstrated its staying power in a volatile marketplace by outlasting competing online payment mechanisms such as e-cash and electronic wallets.
“Clearly, Billpoint was losing money and a failure for eBay,” says Shawn Milne, principal for Soundview Technology Group, a San Francisco-based market research firm. “As a public company eBay has high standards for operating margins so they need to keep that going. PayPal has shown it can beat earning projections and eBay decided to go get them. EBay is going to realize a lot more revenue through PayPal.”
PayPal, founded in 1999 by Max A. Levchin, a recent graduate with a degree in cryptology, has become the payment method of choice on eBay and is reaching out now to other e-commerce sites. PayPal represents about a third of all eBay payments, a figure that is expected to grow as eBay promotes PayPal as a preferred payment option. In comparison, Billpoint transactions on eBay are about one-sixth of those for PayPal. Cash, checks, credit cards and other online payment mechanisms account for the remainder of payments on eBay, which expects to phase out Billpoint over the next several months. EBay will operate PayPal as an independent brand.
“PayPal got a big head start over Billpoint and other competitors in the auction community, largely because it offered incentives to buyers and sellers to try its service,” explains Beth Robertson, a senior analyst with Needham, Mass.-based TowerGroup Inc. “With its ownership of PayPal, eBay is getting that market awareness and presence.”
PayPal debuted on eBay in early 2000. That use was an outgrowth of the company’s first application—securely transferring money between Palm Pilots. Levchin, now 26 and PayPal’s chief technology officer, had a notion to launch a company to create an encryption standard for mobile transactions. In the late 1990s, Levchin met Peter A. Thiel, who ran a large hedge fund. After listening to Levchin’s pitch, Thiel, now 34 and PayPal’s chairman and CEO, agreed to provide the funding to form PayPal. The application hit the streets in October 1999 and attracted 10,000 users by year’s end.
Ease of use
PayPal, with 13.5 million consumer accounts, quickly became popular among consumers as an online payment device because it is easy to use. Consumers fund PayPal accounts by transferring money from bank accounts or credit card accounts to their PayPal accounts. A user establishes an account by providing his or her name as it appears on the bank account or credit card, an e-mail address and a home phone number. A user also selects a password to access the account and provides two forms of personal data, such as mother’s maiden name or date of birth, to verify identity. A user who wants to replenish an account simply instructs PayPal to tap the credit card or bank account. Buyers initiate a payment by clicking on the PayPal icon on the merchant’s web site.
One way eBay expects PayPal to add to its revenues is through PayPal’s lower transaction processing costs. PayPal and Billpoint pay a fee for funds transfer every time a consumer replenishes an account. PayPal pays 3 cents to replenish an account from a bank account using the automated clearinghouse system and 3% using a credit card. About 25% of funds coming into PayPal accounts originate in a bank account at 3 cents per transaction. Another 25% are transfers from one PayPal account to another, costing PayPal virtually nothing. The remaining 50% are from credit cards at 3%. Analysts say that mix adds up to a margin of 65% for PayPal.
By contrast, customers replenish almost all their Billpoint accounts through credit cards, making it difficult for eBay to mark up the transactions to sellers enough to make money. “Billpoint transactions are almost exclusively funded using credit cards, which leaves eBay with about a 35% gross margin per transaction after processing fees,” explains Scott W. Devitt, analyst with Baltimore-based Legg Mason Inc. “PayPal’s gross margin on ACH transactions after processing fees is about 95% and about 100% on PayPal credits.”
PayPal’s margin comes in the difference between what it pays for the money to come into the account and what it charges its 3.5 million merchants to receive the payment. Those sellers pay 2.2% plus 30 cents a transaction for a merchant account and 2.9% plus 30 cents for a standard (individual seller) account. Sellers in good standing can get the lower rate after 90 days.
At the lower rate, PayPal’s merchant fees become more attractive than credit cards to small Internet merchants who lack the volume to negotiate lower rates with credit card processors. The average payment received by PayPal merchants is $55 and is increasing by more than $1 every three months, according to PayPal. At that level, a seller with preferred status will pay $1.51, or 2.74%, for the transaction. Buyers do not pay a fee.
Seeking a jump
Given the modest amount PayPal earns per transaction, it appears eBay will need to realize a tremendous amount of gains in volume and operating efficiency to justify the $1.5 billion paid for PayPal. EBay expects to generate additional revenue through expansion of PayPal’s Web Accept product for small Internet merchants selling goods and services outside of online auctions. Because many small merchants have trouble achieving credit card status but still need a fast, electronic payment mechanism, the company expects Web Accept to be popular. “Web Accept allows small merchants to accept PayPal at their site, which lets them create a more convenient payment experience for consumers,” says David O. Sacks, chief operating officer for PayPal. To sell its services, PayPal will still rely on word of mouth and merchants’ experiences on eBay.
PayPal also will be targeting small Internet retailers and manufacturers selling excess merchandise direct to consumers. These sellers typically discover PayPal through eBay. Once they become comfortable with selling online, they often leave the auction community, establish their own web sites and offer PayPal as a payment option.
Further, some analysts believe that as PayPal becomes a more mainstream online payment mechanism, the company may be able to sign deals with high volume Internet merchants, such as Amazon.com and Buy.com. “PayPal’s niche is with online merchants generating less than $1 million a year in revenue, which is a market with plenty of growth opportunity,” says analyst Devitt. “But if its pricing structure is competitive with card acceptance fees for the largest merchants, there is no reason they can’t sign deals with Amazons of the world.”
Although eBay will say only that it intends to expand PayPal volume on its site and outside the auction community, such a presumption is not far fetched. And in fact, eBay can use PayPal as an entre to sell auction services to retailers, PayPal says. “Our non-auction volume is growing twice as fast as volume through auction sites,” Sacks says. “Some of these merchants sell through e-mail marketing and even offline marketing channels. We provide eBay with an opportunity to present its e-commerce platform to small businesses using PayPal, but which don’t use eBay.”
Many of PayPal’s business accounts offer fixed-price goods and services. During the second quarter of 2002, PayPal’s payment volume from non-auction transactions represented 41% of total payment volume, up from 39% during the first quarter of 2002. PayPal processes 300,000 transactions a day. “There is no question eBay wants to be in other areas of e-commerce besides the auction community,” Sacks says. “PayPal is an online payment processor that facilitates acceptance of credit cards for small businesses, which might otherwise find card fees too high.”
To help further boost non-auction revenues, PayPal recently launched on its web site the Small Business Resources Center. The service provides tools, such as instant payment notification, which lets sellers know when a payment has been posted to their account, and tips on using PayPal to grow a small online business.
PayPal is also promoting its Small Business Developer Network, which encourages software developers to create e-commerce applications for entrepreneurs and small businesses. As of June, 138 PayPal-compatible applications have been developed. Solutions include payments applications for web sites featuring digital content and e-commerce solutions for the Microsoft VisualStudio.Net and ASP.Net platforms. In addition, the company now offers sellers the ability to print United Parcel Service shipping labels directly from their accounts.
“Expanding PayPal as an e-commerce payment mechanism is an attractive portion of their business strategy and was a strong component of negotiations to acquire the company,” says an eBay spokesman. “We feel there is plenty of opportunity to grow PayPal outside and inside the eBay community.”
While eBay is reaching out to non-auction sites with PayPal, experts also expect eBay to place greater emphasis on PayPal payments within eBay. Although about 60% of PayPal’s revenues, which analysts project will total $222 million this year, come from eBay transactions, only 40% of payments made by eBay’s 46 million users originate from online sources, including PayPal. EBay says it hopes to increase that percentage.
Analysts expect eBay to initially try to convert customers who send payment through the mail. Next will be credit card users and finally users of other online payments mechanism, such as Citicorp’s c2it and Yahoo’s PayDirect.
PayPal has already begun marketing in these segments by adding features. One is Auction Finder, which allows winning bidders to pay for multiple purchases through eBay at one time and directly from PayPal’s home page. Another feature is Winning Bidder Notification, which encourages buyers to use PayPal for a successful bid.
Converting to PayPal
Converting users of other payment services to PayPal may require the use of incentives, such as additional credits for opening an account, according to e-commerce experts. “PayPal has certainly been aggressive in growing its business outside eBay, but I think that emphasis will take a back seat as eBay focuses PayPal on its core business,” predicts TowerGroup’s Robertson. “Certainly not everyone is going want to use PayPal and eBay will recognize that because they are not in business to lose sales. But as eBay grows its volume, PayPal is likely to grow in accordance. And as an eBay-owned PayPal increases its market share, the opportunities for competing online payments services to grow on eBay will be limited.”
Anxious investors are certain to want to see rapid growth by both companies to ease concerns that it may take eBay years to realize a satisfactory return on investment. At $1.5 billion, eBay will pay a hefty premium for PayPal, which it reportedly attempted to acquire in 1999 for about $800 million. When PayPal refused to sell, eBay bought Billpoint.
But eBay also shelled out $43.5 million in February to buy out Wells Fargo’s equity position in Billpoint. For PayPal, eBay is offering 0.39 shares of its stock per outstanding share of PayPal stock, plus another $18 million in cash.
“EBay didn’t lose sight of PayPal and while they paid a lot to increase their cash flow and move into new segments of e-commerce, PayPal represents incremental profits and a way to build its core business,” says Soundview Technology’s Milne.
While eBay reportedly has the cash to cover the cost of buying out Wells Fargo, recovering the premium to acquire PayPal is not a slam-dunk.
First, PayPal has yet to receive a money transfer license in 14 of the more than 30 states requiring them. This is not considered a major obstacle, since the Federal Trade Commission recently ruled PayPal is not a bank, therefore making it eligible for such a license. But in February Louisiana banned PayPal from offering services within the state claiming it constituted an unauthorized banking service. Although Louisiana has since granted PayPal a money transfer license, PayPal is still awaiting approval for similar licenses in about 16 states.
“PayPal has won some big victories on this front of late with the FTC ruling and New York’s decision not to classify it as a bank, but there are still a lot of states from which to gain a money transfer license,” says Legg Mason’s Devitt. “So far they have a good track record of receiving approval.”
More nettlesome are the class action suits filed against the company by disgruntled users (Not everyone loves PayPal, p. 28). Although PayPal and eBay say only that the suits are without merit, the negative publicity surrounding them has the potential to steer wary non-PayPal customers away from the service.
The suits, one of which was filed in Santa Clara, Calif., in February, charges PayPal with illegitimately restricting customers’ access to their money and seeks an unspecified amount in damages. The plaintiffs argue that eBay’s fraud prevention strategy is heavy handed and guided by poor management strategies that freeze accounts without actual proof of fraudulent activity.
Keeping the magic
“It’s still possible for this and any other suits to be a problem,” cautions Robertson. “The concern is that fraud prevention practices may prove to be unreasonable. There is certainly some room for refinement in this area.”
Lastly, PayPal’s association with online gambling may come back to bite the company. Missouri and New York recently subpoenaed PayPal for records of its customers. While eBay says only that PayPal intends to exit the online gaming industry, whether regulators intend to use the requested data against PayPal remains a question.
Those problems aside, PayPal looks to be more than a good fit for eBay. After all, both companies were dot-com upstarts that devised a simple way to serve customers in a fast growing and lucrative segment of e-commerce and turn a profit. Now that the two companies are to become one, it remains to be seen if they can continue the magic that defined them separately. l
Peter Lucas is a Chicago-based business journalist.
Until now. Much as PayPal grew up because someone had
the notion that consumers could exchange value without involving a card, a new
product called Bill Me Later is a credit vehicle for the web without the card.
Produced by I4 Commerce Inc., Bill Me Later, after six months of beta testing
with a handful of merchants, this fall is implementing payment at a string of
online merchants who will accept Bill Me Later in time for holiday shopping.
Bill Me Later allows web shoppers to pay for items through
monthly installments on a line of credit provided by I4 Commerce, a 2-year-old
company funded by credit card processing giants Paymentech and First Data Corp.
and venture capital firms Azure Capital and Crosspoint.
Buyers who click on the Bill Me Later payment option on a checkout page provide only a birth date, which, along with the billing information they have already filled out, I4 Commerce uses to authorize the transaction. The purchase is authorized (or rejected) in about the same time as a credit card transaction.
By allowing for credit payment without using a credit card account number, Bill Me Later hopes to eliminate what consumers say—rightly or not—is one of the biggest obstacles to Internet shopping. “Security is the number one concern cited by Internet users who do not shop online,” Jim Ellis, director of merchant development, told attendees at the eTail conference in August. “And it helps explain why 52% of people abandon shopping carts on the web when they are asked for a credit card account.”
EBags.com, which has been offering the Bill Me Later option to customers since mid summer, believes that about 50% of customers who choose that option either don’t have credit cards or are maxed out on their cards, meaning the option has allowed it to save some sales. But with only 1% to 2% of customers paying with Bill Me Later, eBags can’t quantify the benefit. Peter Cobb, eBags’ director of marketing, characterizes the volume as acceptable, given that only 50% of shoppers see the option and it appears only deep in the shopping cart.
I4 Commerce expects to set its discount rate at about 1.5% vs. the 1.8% to 1.9% that major merchants pay Visa, MasterCard and American Express for web purchases.
What makes Bill Me Later a serious contender for web-based retail payments is the fact that First Data and Paymentech, which is co-owned by First Data and Bank One, together already process more than 80% of card-not-present credit card transactions. They have added Bill Me Later to their processing portfolio, the first such new payment option they have accepted since Discover Card in 1998. Bill Me Later also has established partnerships with a number of major e-commerce processors. “All any retailer needs to do to use Bill Me Later is upgrade to their payments processor’s latest software release,” Ellis says.
To date, Ellis says, I4 Commerce has approved 98% of Bill Me Later authorizations for buyers with credit cards, about the same approval rate as online credit card payment. And surprisingly, it has even approved—and thus granted credit to—about 35% of Bill Me Later applications submitted by purchasers who have no credit card.
