PayPal Spreads Its Wings

The Web service is going beyond parent eBay. Will the next foray be offline?

The wise folks at Detroit Coffee Co. aren't trying to create the next Starbucks Corp. (SBUX ). They sell only basic brew from retail vans. On their Web site you won't find beans with foo-foo flavors. And they don't take American Express (AXP ) -- or Visa or MasterCard. The only way to buy online: PayPal, the Web payment service owned by online marketplace eBay Inc. (EBAY ). Detroit Coffee Chief Executive George B. Kaufman thinks PayPal, which lets buyers instantly send money over the Web without typing in their credit-card numbers, is easier and safer than plastic. Besides, he adds, "almost everybody recognizes PayPal now."

Less than three years after eBay acquired it for $1.5 billion, PayPal aims to bust out of its parent's confines. Even giant eBay, after all, accounts for less than 10% of all e-commerce, so there's a much bigger opportunity outside. So far, PayPal has signed up a variety of independent merchants to offer its service, from small fry such as Saylor's Pizza in Hendersonville, Tenn., to big fish like retailer (OSTK ) and Apple Computer's (AAPL ) iTunes Music Store. And it's quickly moving overseas, opening local Web sites in eight countries in the past year. The goal, says PayPal President Jeff Jordan: "We want to be the standard for online payments."

It's a grand ambition. After all, PayPal made its name helping eBay sellers, often too tiny to qualify for a conventional credit-card merchant account, avoid the time and risk of waiting for paper checks. Buyers click on a PayPal link, and they're whisked to their account at PayPal. The service draws money from any of several sources buyers have chosen -- credit or debit card, checking account, or PayPal account, where they can keep funds from auction sales. Although PayPal is legally just a money transfer agent like Western Union Financial Services Inc. (FDC ), it's more like virtual plastic to consumers and merchants.

And more than ever, PayPal is knocking elbows with Visa, MasterCard, and the banks that issue their cards. It just passed American Express, the leading bank card issuer. PayPal now has 72 million worldwide accounts, compared with AmEx's 65 million. Yet that pales next to card associations Visa International and MasterCard International Inc., with 1 billion and 680 million cardholders, respectively. Likewise, PayPal's $19 billion in total payment volume last year falls far short of Visa's $3 trillion from all of its member banks. PayPal, however, is expanding much faster -- 44% last year, to Visa's 14%.


All that has some analysts raising an even more intriguing possibility: Could PayPal become a full-fledged credit brand on par with Visa -- perhaps even beyond the Web? Jordan won't cop to that ambition, but PayPal is constantly comparing itself with banks and credit-card companies, claiming lower fees and less fraud risk. Last year it also inked a deal with GE Consumer Finance (GE ) to offer buyers lines of credit for the first time. Analysts speculate that it's only a small step from there to an independent PayPal-branded, GE-funded card that directly takes on Visa, MasterCard, and their member banks. Says analyst Scott N. Devitt of Legg Mason Wood Walker Inc.: "PayPal has the platform to challenge the credit-card infrastructure over time."

Truth be told, that time could be years away -- especially off the Web. But potential rivals are already on guard. Tim E. Attinger, Visa's senior vice-president for product development and management, referred to PayPal as a "niche" three times in a 25-minute interview. "Visa has built a pretty strong relationship with large merchants and small mom-and-pop operations," he says. "And at the end of the day, consumers want to put as much of their purchases [as they can] on the payment vehicle they know and trust."

For now, he's right. To appeal to large merchants outside eBay, let alone the general public, PayPal has enormous tasks ahead. It must stay ahead of crooks who target PayPal members with e-mails to fool them into revealing account information. At the same time, it may need to modify its stringent antifraud measures, which can rankle merchants. For instance, when a buyer has a dispute with a merchant, PayPal can freeze a merchant's entire account while it investigates.


PayPal's growth is crucial for eBay, whose stock has fallen 43%, to $32.75, since Jan. 1. The reason: First-quarter revenues in its core U.S. marketplace increased only 19%, the slowest pace in its 10-year history. PayPal's revenue, up 47% last year and on track to hit nearly $1 billion this year, is helping to make up for the shortfall. "EBay is increasingly relying on PayPal for its growth," says former PayPal marketing executive Eric M. Jackson, author of the 2004 book The PayPal Wars.

That's not the only way PayPal can help eBay reverse its slowdown, which may well be the result of mounting competition. Increasingly, (AMZN ),, and Google (GOOG ) are offering new selling venues to eBay's merchants, some of whom are angry at recent fee hikes. EBay has been branching out, too. It's buying or opening classified ad sites around the world and expanding its separate online storefronts for merchants. PayPal could provide a common way for larger merchants to sell across all those venues, using one payment system to track orders, payments, and sales trends.

PayPal's pitch to merchants: For one, lower merchant fees. Nearly half its members' payments are funded directly from their bank accounts, bypassing credit-card interchange fees. While PayPal doesn't reveal specific merchant fees, selling a 99 cents song download costs a merchant such as iTunes Music Store 16 cents or more in credit-card processing fees, but only 9 cents in PayPal fees. "This hybrid funding model allows them to undercut rivals," says Allen Weinberg, managing director at Glenbrook Partners LLC, a Menlo Park (Calif.) financial services consultant.

PayPal also claims that merchants suffer less fraud using its service than with credit cards. PayPal and eBay combined have more than 1,000 people fighting fraud. PayPal says it has developed its own risk models to detect fraud, as well as a patent-pending method of verifying buyer bank accounts. As a result, PayPal estimates its merchants' losses from fraud on its service are only 0.17% of their revenues. That compares with average losses of 1.8% for online merchants that take credit cards, according to payment processor CyberSource Corp. (CYBS ). "Fraud is clearly lower on PayPal," says Stuart Wallock, director of marketing for Web electronics retailer, which takes both PayPal and credit cards.

Adding PayPal often gives merchants a nice bonus, too: new customers. Some are folks who don't have credit cards or hesitate to use them online. Others have money in their PayPal accounts -- $750 million overall -- that tends to burn holes in their pockets, in contrast to credit accounts where people know a bill will be coming. Tech e-tailer TigerDirect Inc. found that nearly 90% of customers using PayPal were new to the site.

With some high-profile wins such as iTunes Music Store, PayPal is starting to prove it can leave the eBay nest. How high can it fly? "I'm not sure they have enough to offer a Macy's (FD ) or a Best Buy (BBY )," says JupiterResearch analyst Bruce Cundiff. With the help of the small merchants that make up eBay, PayPal managed to thrive against the credit-card giants. As it ventures onto their turf, PayPal will have to make much bigger friends.

By Robert D. Hof in San Jose, Calif.

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