EBay's Profitable Pal

PayPal—and other electronic payment services—are wooing more and more consumers and merchants, and becoming the quiet stars of e-commerce

A disappointing revenue forecast and news that longtime eBay (EBAY) CEO Meg Whitman would soon retire overshadowed the real star of the e-commerce company's Jan. 23 earnings report: PayPal. The business purchased by eBay in 2002 handled almost $50 billion in payments during the year, up more than 30% from the prior year. Along the way, PayPal generated $1.9 billion in processing fees for eBay, giving company executives plenty to crow about on their conference call with analysts. "PayPal is a fabulous business, it's growing fast and has the kind of accelerating momentum we love to see," said CEO-designate John Donahoe. Whitman called the company, in short, "a gem."

PayPal's success mirrors the growing popularity of electronic payment services. About 14% of online payments in the U.S. are made with credit-card alternatives, such as PayPal, Google (GOOG) Checkout, and Bill Me Later, according to a recent report by Javelin Strategy & Research. PayPal and peers have a long way to go before matching the scale of long-established payment services such as Mastercard (MA), which processed $577 billion in the third quarter alone, but the upstarts' share of online payments will only increase. By 2012, roughly 30% of U.S. online transactions will go through such services, according to the Javelin report.

Why not just put it on a Visa? Experts point to three main drivers for alternative payments: concern over fraud risk, growth in merchant participation, and fear of, or lack of access to, credit cards. Use of online payment services is likely to accelerate in the coming year, says Bruce Cundiff, Javelin's research director. "PayPal is gaining this following and that is essential," he says. "In five years, we forecast that PayPal will represent more than 10% of online transactions."

Credit-Card Alternatives Identity theft has grown more than 50% since 2003 (BusinessWeek.com, 11/21/07) as people release more sensitive information online, according to Gartner (IT). To protect users, online payment alternatives won't pass a credit-card or checking account number to a merchant. Instead, PayPal and others typically deliver funds through an intermediary account that in turn draws on a bank or credit account. The payment service can receive funds from the underlying account; the merchant cannot.

Alternative payment services typically report lower rates of fraud than major credit-card companies. Of the total amount that PayPal processes, it takes a fraud loss on 0.26% of transactions, or a fraction of the typical fraud loss rate of about 1% for online merchants. And on Jan. 28, eBay acquired Fraud Sciences, an Israeli provider of online fraud detection tools, for $169 million in hopes of further reducing its vulnerability to criminals. "We know why buyers want to use PayPal is for security," says PayPal spokesperson Amanda Pires. "So we need to advance and stay ahead of fraudsters."

Another reason online payments are gaining greater traction is that more retailers and other merchants are using them. When alternative payment services began emerging in the mid-to-late 1990s, many merchants saw little benefit in allowing an unknown, untrusted company to process payments—not when most shoppers, in the U.S. at least, had viable credit cards. "In the early years, we had to do a lot of evangelizing," says Mark Lavelle, Bill Me Later's vice-president of corporate development. "Yes, your customers have credit cards, but that doesn't mean that is the only way they want to pay."

As a result of merchant reluctance, payment providers often had to tie themselves to an e-commerce mall of sorts, like PayPal did with eBay. It was that or settle for the transactions that credit-card companies refused to process. E-wallet companies such as Neteller (NLR.L) and FirePay were once listed on major gambling sites as preferred payment methods. As the U.S. cracked down on online gambling, these services were cut off from a major source of their revenue (BusinessWeek.com, 1/17/07). Several, including FirePay, subsequently closed down.

Getting More Merchants on Board PayPal and others try to woo merchants with the promise that buyers will be more likely to complete a purchase if they can do it with a single click—say, on a PayPal button—rather than having to enter their credit-card numbers and other details. When that hasn't worked, payment services point to the fact that their processing fees are often lower than those of major credit-card providers. Some offer other incentives. For example, Google offered payment processing credits to its search advertising customers in a bid to fuel adoption of its Checkout payment service.

Such appeals are working. PayPal's off-eBay business grew 66% in the fourth quarter, processing $6.1 billion in payments for Web retailers such as Dell (DELL), Blue Nile (NILE), and Yahoo's (YHOO) shopping sites. Lavelle says Bill Me Later is available on 700 Web sites. PayPal also has helped its e-commerce penetration along by partnering with more accepted credit-card providers. In November, the company released a tool that generates a one-time Mastercard number (BusinessWeek.com, 6/15/07) on sites that don't accept PayPal, expanding its potential use to any online store that takes that major credit-card provider.

Growing concern about credit-card debt in the U.S. and lack of credit-card penetration abroad is also fueling growth. Payment systems such as PayPal-like MercadoPago, the Latin American payment system owned by eBay protege MercadoLibre (MELI), offer users in Argentina, Brazil, Mexico, and Venezuela who don't have a credit card a way to pay for online transactions. In 2006 the company processed $89 million in transactions. In the U.S., services such as Bill Me Later give users an installment plan that serves as an alternative to paying up front with a debit card. And unlike many credit cards, Bill Me Later's option doesn't carry high interest fees. "We do get people who don't have credit cards by choice," Lavelle says.

As the online payment bug spreads, eBay's Donahoe may be proved right in his assertion that "2008 will be PayPal's best year yet."

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