eBay Grooms Another Phenom

Obstacles aside, the company's PayPal unit may ultimately wind up its most celebrated business.
By Kevin Kelleher ,

Here's a little-known fact about eBay (EBAY) - Get Report: It's not one of the most successful e-commerce companies in the world.

It's actually

two

of the most successful e-commerce companies in the world -- eBay, the global network of auction and retail sites, and PayPal, its online-payment technology subsidiary that fuels the bulk of eBay transactions. Of the two, PayPal may emerge as the bigger phenomenon in the long run.

In making PayPal the most common method of payment on its sites, eBay has slowly incubated the technology, working out its kinks and tightening up the seams that could make buyers and sellers alike consider it a lot easier, cheaper and safer to use than credit cards -- the default method of payment for online consumer transactions for now.

"In our wild aspirations, we think PayPal has the potential to be as big, if not bigger than, eBay," says Jeff Jordan, the eBay executive in charge of the PayPal subsidiary. (That Jordan was named PayPal chief in December after a five-year stint overseeing eBay's North American operations shows how seriously eBay is taking PayPal.) "But we have a whole lot of executing to do before we get there."

Jordan isn't exaggerating on either count. It's hard to overstate how far PayPal is from dethroning Visa, MasterCard and American Express as the three kings of online payments, but the opportunity is eBay's to botch. PayPal contributed only 21 cents of every dollar the company made in revenue last year, but it grew faster -- 59% compared with a 48% growth rate for the rest of eBay.

Analysts and investors are starting to wake up to the fact that PayPal may be more than just a technology to benefit eBay sellers. "We believe

PayPal could be one of the more misunderstood and undervalued initiatives that the company is working on," said Scott Devitt, an analyst at Legg Mason. "PayPal has the platform to challenge the credit card infrastructure over time." (Legg Mason has no underwriting relationship with eBay.)

eBay's gross merchandise volume -- the total amount of goods traded through its global sites -- reached $34 billion last year. Compare that figure to world economies, and eBay's marketplaces would rank 88th, right behind Kuwait and Kenya. But to put PayPal's potential in perspective, the gross merchandise volume of all merchant services (that is, the volume of all consumer merchant transactions made online) is $300 billion, which would make it the 29th largest economy, ahead of Saudi Arabia.

eBay paid $1.5 billion for PayPal in 2002, a figure that struck observers at the time as too rich but which seems like a bargain two and a half years later: PayPal is now worth between $6 billion and $7 billion, estimates Legg Mason. The merger has helped both companies grow: eBay gave PayPal a critical mass it needed to succeed, and PayPal gave eBay a higher transaction volume, as buyers and sellers took to its format.

"The advantage eBay has is the 450,000 individual small merchants using PayPal on eBay," says Mark Mahaney, an analyst at American Technology Research, which does no underwriting for companies. "There's the risk that eBay wastes time and money pushing PayPal off its sites, but it strikes me as an open opportunity for them."

The task that eBay faces as it moves PayPal beyond its sites is winning acceptance from online merchants, whether a niche seller or a Fortune 500 giant. Retailers have been grumbling about high fees that the handful of major credit card companies charge for transactions, a discontent that opens the door for PayPal as a cheaper alternative.

PayPal is farther along in reaching that potential than many suspect. After only five years, PayPal handled payments for 9% of consumer e-commerce transactions in the U.S. and 5% globally. And it has signed up 64 million accounts around the world, a million shy of the number of people who hold American Express cards.

In the past year, PayPal has sown seeds to reach out to non-eBay merchants. Last May, it released an application programming interface to software developers, a move that helps e-tailers plug their online storefronts directly into PayPal technology. In December,

Apple's

(AAPL) - Get Report

iTunes store began accepting PayPal payments.

However, PayPal's expansion raises delicate issues for eBay. For one, credit card companies won't be thrilled to welcome PayPal as a competitor, and neither will the banks that issue their cards. Jordan says PayPal has "a strong symbiotic relationship with credit card companies. We're addressing a part of market that historically they have not been able to strongly address" -- the millions of small merchandisers whom the credit card companies couldn't afford to underwrite.

But PayPal is already moving away from credit cards, which are more expensive for the company to handle than other means of payments, such as direct payments from bank accounts. Right now, fewer than 53% of PayPal U.S. payments are financed from consumers' credit cards, down from 56% in two years.

PayPal faces other obstacles such as fraud, a devil that has dogged eBay from the start. PayPal does a good job of using sophisticated models to minimize the risk it assumes in online transactions, but it only takes a couple of high-profile fraud cases to scare away potential users. Right now, phishers who try to net PayPal passwords are a looming threat.

Another reason why PayPal may want to keep a low profile as long as possible: competition. PayPal bought out or outlasted several startups with similar business plans, but the more it succeeds, the more new rivals will appear. Visa or MasterCard may find the best way to fight PayPal is to create their own versions. And there's talk that

Google

(GOOG) - Get Report

may be contemplating a PayPal-like service. Asked about such plans at its analyst day last month, Google executive Larry Page answered with a noncommittal, "Who knows?"

And still another obstacle, some eBay watchers say, is eBay itself. "There may some conflicting visions of what to do with PayPal inside eBay," says Eric Jackson, author of

The PayPal Wars

and a marketing executive at PayPal before its purchase by eBay. "To the extent that eBay makes payments safe and easy anywhere, it's essentially robbing eBay of potential revenue."

For now, the debate inside eBay seems to be favoring letting PayPal off the leash, but under tight supervision. "eBay may be cannibalized by non-eBay merchants using PayPal," says Jordan. "But you can't be the global standard in online payments and just serve one marketplace. I don't want to help competition but the reality is, if PayPal isn't servicing their payment needs, someone else will. It's a myopic strategy to boost eBay at the expense of PayPal."

That's good news not only for PayPal, but also for eBay investors who were spooked about what may have been early signs of a slowdown in growth for the company's core marketplace operations.

It's too early to tell whether, as some analysts suggest, eBay is seeing more eBay sellers move out on their own. But if so, one of the companies that could benefit most could turn out to be PayPal.

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