The successful payments service of eBay has aligned with Apple and Paymentech as it seeks to grow beyond the online auction market it dominates.
The card industry can get a little smug sometimes. Credit and debit cards are becoming the dominant form of consumer payment as checks fade and more markets open to accepting plastic. Executives, however, should be careful before writing off the competition.
PayPal Inc. is not so quietly becoming a force to be reckoned with, starting first as an online auction payment device. PayPal's transaction and dollar volume have gained ground, and now the company is laying the groundwork for expansion beyond its auction beginnings.
Whether that means credit cards, which dominate Web spending, now face a direct threat from a powerful new competitor or simply that a new option is available for payments that probably wouldn't go to cards anyway is unclear. PayPal already has close links to card payments because users can fund PayPal accounts by using credit cards. But there's no question that PayPal is the payments player to watch in 2005.
PayPal began in 1998 and quickly made a name for itself as a convenient way for consumers to make person-to-person payments, primarily on the Web site of online auction giant eBay Inc. Merchants, especially smaller sellers that hadn't become card acceptors, flocked to PayPal as a painless way to serve buyers from across the country.
The company makes it relatively easy for a seller to get started with minimal fees and moderate paperwork. Both merchants and consumers can fund their PayPal accounts with their bank accounts and their Visa, MasterCard, Discover and American Express card accounts.
Those entreaties to both sides of a transaction, coupled with San Jose, Calif.-based eBay's powerful rise as a major Internet company, have made PayPal a payments success story.
Clinching the deal was eBay's purchase of PayPal for $1.5 billion in 2002. By that time, PayPal had become the leading payment choice for buyers on eBay, controlling about two-thirds of the Web auction payment market, according to Jupiter Research. PayPal has deftly fended off a number of competitors, including PayDirect from Yahoo! Inc. Just last October Yahoo said it would close PayDirect completely by this May. With Yahoo's void, PayPal's primary auction-payment competition is down to money orders, cash and checks.
Joining eBay has proven a boon. In 2004's third quarter, PayPal reported 56.7 million accounts, up 61% from the same period in 2003 (chart, page 16). At the same time, it had 17.4 million active accounts compared to 11.2 million in 2003, a 55% increase. PayPal defines active accounts as those that sent or received at least one payment through its system during the quarter.
Total payment volume tallied $4.6 billion in 2004's third quarter, up a modest 6% from the second quarter, but a 52% rise from $3.0 billion in 2003's third quarter. The service operates in 45 countries and five currencies-the dollar, yen, Canadian dollar, British pound and the euro.
Beyond eBay
PayPal brags that one in three online shoppers in the U.S. has a PayPal account. Experts estimate that it is the third most popular online payment brand following Visa and MasterCard but leading Discover and American Express.
The positive financial results were accompanied by a number of strategic alliances and system changes in 2004. And this year is shaping up as a turning point for the firm as it also is expanding internationally.
"They are a fascinating story and one of the big successes of the Internet era. They are still growing," says Gwenn B?zard, formerly a senior analyst with Boston-based Celent Communications who followed e-commerce closely before leaving in January to join AITE Group, a new financial research and consulting firm.
PayPal's dominance of the auction payments arena has it seeking to grow its presence in all online payments. This means signing up major merchants and processors, says Todd Pearson, general manager of merchant services.
One major goal is building up consumer use of PayPal for general online purchases. At the end of 2004, about 70% of all PayPal payment volume came from online auction purchases with 30% going for other purchases. Pearson wants to see that 30% grow as a percentage of payment volume, though he declines to disclose a precise figure.
"In the U.S. we have the network, functionality and user base," he says. "Now we need to apply that to the user base outside of eBay."
It may not be easy. The auction market has accounted for at least two-thirds of PayPal's payment volume since its beginnings.
This year PayPal plans to sign up more small and medium-sized merchants that may already have a merchant account through an independent sales organization. The focus is on merchants with annual sales ranging from $250,000 to $5 million, says Pearson.
PayPal took two giant steps in December to reach these merchants. Paymentech L.P., the merchant acquirer that has a hand in over 50% of all Internet transactions, agreed to offer PayPal as a payment option to its merchants for card-not-present transactions. Paymentech also agreed to create a team to market PayPal to its merchants.
Aligning with Paymentech is an important win. In 2003, it processed a total of 7 billion transactions worth $162 billion in sales volume. And Paymentech's pedigree sends signals that PayPal has arrived. The Dallas-based processor is co-owned by First Data Corp. and J.P. Morgan Chase & Co., which garnered its stake as part of its purchase last year of Bank One Corp. Chase owns 52.5% of Paymentech and First Data the rest.
Shortly after that announcement, PayPal formed a deal with another high-profile firm, Apple Computer Inc. Apple agreed to accept PayPal for its online iTunes song store, the chief way to buy music for the super-hot iPod portable music player. Consumers can buy subscriptions to iTunes or opt for individual purchases of 99 cents per song. In December, Cupertino, Calif.-based Apple announced that iTunes had sold over 200 million songs.
The two began their alliance with a promotion that gave five free songs to the first 500,000 customers to open a new iTunes account in the U.S. using PayPal as their payment vehicle.
Apple's Coattails
"Working with iTunes is important because it shows we are accepted by a major name-brand merchant. That reflects well on us in the marketplace," says Pearson. It's a bonus that many PayPal users happen to shop at iTunes, he adds.
The deal also opens up opportunities in micropayments, but Pearson says PayPal hasn't decided if it will expand further in that market. Interchange and related card-acceptance costs make such small transactions problematic, according to Pearson. And keep in mind that using PayPal to buy iTunes makes it easy for consumers to buy multiple songs at a single sitting, says Pearson, so a random transaction is rarely just 99 cents.
Pearson says that PayPal seeks to partner with other name-brand merchants, and would like to expand the relationship with the computer maker. Apple runs some brick-and-mortar stores, providing an opening for PayPal beyond Web payments.
"The deals with Paymentech and iTunes are signs that PayPal will aggressively strike deals outside the auction market," says B?zard. Micropayments could become a good niche, "but it will not become a major revenue driver," he says.
PayPal also is improving its systems and re-jiggering some of its programs for merchants. Last spring it began so-called Application Program Interfaces (API), a redo of its computer systems designed to make it easier for Web merchants to interact with PayPal. In layman's terms, API benefits merchants because it "reduces the steps needed to address (customer) returns, credit the consumer's account and other customer-service needs," says Pearson.
The API upgrades will make it easier for large, "off-eBay" merchants to interface with the PayPal system.
"Merchants doing $2,000 to $50,000 online need different tools from us," Pearson says. "This (API) is for a different class of merchants."
In a move designed to be both pro-merchant and pro-consumer, PayPal in September doubled its Buyer Protection program from $500 to $1,000. The program gives buyers a guarantee up to that amount when a seller doesn't deliver a purchased item or the buyer considers the item as delivered to be significantly different than described. Merchants must earn their participation in the program, first by receiving feedback from at least 50 unique or repeat customers, and secondly by earning positive feedback from a minimum of 98% of the customers.
The requirements appear quite rigorous but online merchants seek to participate because it gives them a seal of approval, a stamp to post on-site to convince buyers their store is no fly-by-night operation. Sellers based in the U.S., United Kingdom, Germany and Canada can offer Buyer Protection.
PayPal estimates that the $1,000 cap means the program will cover about 80% of the items listed on eBay, up from 70% earlier.
PayPal also modified its pricing format for U.S. merchants last year, moving to a volume-based, four-tier model from a two-tier model. Merchants receiving more than $100,000 in payments a month are charged the cheapest rate, 1.9% of a transaction plus 30 cents. On the other side are merchants receiving payments of $3,000 or less a month who pay 2.9% of the sale plus 30 cents. Meanwhile, PayPal fees are relatively few and far between, with merchants seeing no monthly, set-up or gateway charges.
The news wasn't all good. In October PayPal experienced system problems that kept some users from logging on, and prevented others who had gotten through from making a purchase. PayPal blamed the snafu on a system upgrade that proved unable to handle peak traffic levels. The problem was fixed in less than a week but not before it became an international black eye. Not fun, but better than a more damaging system meltdown or hacker attack.
Fighting fraud is one of PayPal's strong points. It learned after being hit early on by money-laundering scams that primarily affected the company itself and not its customers, according to B?zard. Its transaction loss rate was less than 0.30% in 2004. Granted, part of that is because the average PayPal transaction is about $53, says B?zard.
'Out There Early'
PayPal's fraud-reduction efforts also have been successful in part because PayPal requires consumers to provide dual authentication-a user name and a password, says Michael A. Keresman III, chairman, president and chief executive of CardinalCommerce Corp., a provider of authentication services. "They were out there early," he says. "The second factor of authentication has proven a very effective deterrent (to fraud)."
PayPal began working with Mentor, Ohio-based CardinalCommerce last summer so its merchants could offer authentication services such as Visa's Verified by Visa and MasterCard International's Secure Code. CardinalCommerce also acts as a code translator for transactions moving between PayPal and Paymentech. PayPal additionally is working with fraud-fighting Internet processors Retail Decisions (ReD) and CyberSource Corp.
From the Web's beginnings as a marketplace, many consumers have been reluctant to put any of their card information online due to fraud concerns. PayPal has made those consumers "feel comfortable with authentication. It makes person-to-person payments easy," says Keresman. "It appeals to a market that has not been appealed to very well."
Today, PayPal has a number of options for growth.
International business is becoming key. PayPal launched its U.K.-specific site in 2003, and tailored in-language sites for Germany and France in 2004. Executives believe these national sites will build on the 18% of total payment volume that foreign sites produced in last year's second quarter.
Parent eBay is building its own business that comes from outside the U.S. International accounted for 30% of eBay's revenues in the third quarter, up from 21% in the same period in 2003.
In the U.K., PayPal formed an alliance with the domestic debit card network Switch, the 20-million-card-strong brand that is part of MasterCard's Maestro debit system. MasterCard is converting Switch to Maestro.
The tie to eBay again looks to be critical if PayPal is to expand around the world. Most of the 224,000 online stores eBay hosts are U.S.-based, but a formidable 81,000 are located overseas.
PayPal also is researching mobile commerce. In the fall it disclosed it was seeking a senior product manager in the U.S. to oversee its expansion in the field. A spokesperson declined to comment beyond a basic job description.
B?zard sees mobile payments as intriguing for PayPal as it seeks more niches, like micropayments, to grow beyond auction payments. Meanwhile, it could decide to buy an Internet gateway to become a more integral part of the payments network.
Consumers have flocked to eBay because they can shop anywhere and buy anything from rare cheese to the 10-year-old grilled cheese sandwich with the supposed image of the Virgin Mary that sold late in 2004 for $28,000.
Meanwhile, PayPal carries a strong brand name and cash flow, a thriving international presence, and a reputation for smart strategic thinking. But in the near term it should focus on its foundation, B?zard says.
"The thread is solving small-business payment needs," he says. "PayPal is a payment service to small business whether online or offline."
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