PayPal: The Closing Window of Opportunity to Broaden the PayPal Acceptance Brand
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
October 2, 2014
PayPal: The Closing Window of Opportunity to Broaden the PayPal Acceptance Brand
- Having established its brand as an aggregator for small e-commerce merchants (making it easier for them to accept credit cards by riding on PayPal’s payment gateway and merchant “acquiring” account), PayPal’s strategic opportunity was to become a branded network through:
- Extending its acceptance brand to larger e-commerce merchants (who did not need PayPal’s aggregation services because they had scale to establish their own merchant acquiring account and payments gateway) but who valued the potential for lowering cart-abandonment costs among the 150mm PayPal customers by removing the need for them to enter card credentials (with the attendant increase in security risk and inconvenience).
- Encouraging consumers to enable low-cost funding options such as ACH-enabled payments (equivalent to electronic checks), the PayPal balances arising from receipts from eBay transactions, and private-label credit (both through Bill-Me-Later, now rebranded PayPal credit, and through the PayPal-GE private label card).
- This strategic opportunity now seems less realizable because EMV tokenization, aside from being a cornerstone of Apple Pay, has enabled products like Visa Checkout and MasterCard MasterPass which allow consumers to pay online using a user name and password (rather than card credentials). In other words, e-commerce merchants can reduce cart-abandonment risk with these digital acceptance brands and do not need to turn to PayPal and its additional fees burden.
- Visa Checkout and MasterCard MasterPass, along with Apple Pay, also enable in-app payments and so compete with PayPal’s app in the “one touch” space for in-app payments. Had PayPal been included as a payment method for Apple Pay, its goals for extending the acceptance brand to m-commerce, and to physical point-of-sale through “mobile” payments, would have been furthered. However, it was excluded likely at the insistence of the networks who are concerned by at the possibility of PayPal broadening its acceptance brand precisely because of the related risk they can then be disintermediated.
- PayPal has also sought to extend its acceptance brand to in-store purchases by allowing a customer to access their PayPal account through entering a mobile ‘phone number and PIN into the payment terminal of a participating retailer, and signing up retailers through an acquiring partnership with DFS. However, DFS suggests this “train has not left the station”; in the meantime, retailers (such as PNRA) are implementing conveniences that PayPal has marketed such as skip-the-line and order-ahead through their own apps.
- PayPal still has an important value-added role as an aggregator for smaller e-commerce merchants but its ability to expand e-commerce share beyond the present 8-9% through extending the acceptance brand to larger e-commerce and app-and-mortar merchants, and to then build out a branded network, has been limited. As such, the relevant valuation compare is more likely 16-18x for acquirers (such as HPY and GPN) at the lower-end and closed-loop, private-label solutions such as ADS at the upper end rather than the 20-22x for V and MA. If PayPal generates pre-tax earnings of $1.7bn in 2015 (assuming 12% growth in 2015 operating income and a 25% allocation of corporate overhead), this corresponds to a valuation range of $18-20bn. In practice, PayPal’s operating income has been flat over the last three quarters (see Exhibit).
Exhibit: PayPal Results reported from Payments Segment of eBay
PayPal and Apple Pay: Different Core Businesses
The core businesses of Apple Pay and PayPal are different.
PayPal makes it easier for small e-commerce retailers to set up for accepting credit cards for payment by allowing them to leverage PayPal’s “payments gateway” (which submits transactions to Visa and MasterCard for authorization), and PayPal’s “merchant account” (against which Visa and MasterCard settle approved transactions). From the perspective of the payments ecosystem, PayPal is a merchant “aggregator” in that it acts as the merchant-of-record for card transactions in place of its merchant-clients who are the ultimate providers of goods and services to the consumer. PayPal’s standard fee to these end-merchants is 2.9% of transaction value plus 30 cents (equivalent to 3.6% on an average $40 transaction).
Apple Pay provides a service to card issuers by allowing them to provision card credentials into a secure element on the iPhone 6 so that this phone can be used in place of a plastic card for a “mobile” payment (by tap ‘n’ pay at a point-of-sale terminal which is wirelessly enabled with NFC for a purchase in a store) or for an “m-commerce” payment (via a “pay with Apple Pay” button in an app for a purchase over the internet). Through TouchID, Apple also provides issuers with a fingerprint risk-score which can help them reduce fraud losses. From the perspective of the payments ecosystem, Apple Pay takes the place of the manufacturer of card plastic and, in authenticating cardholders through biometrics, occupies the role of “token assurance provider”. Apple’s standard fee to its issuer clients is reportedly 15 basis points of transaction value
Among the several distinctions between PayPal and Apple Pay arising from these different business models are that: (i) merchants need to be represented on the Visa/MasterCard systems through a merchant account in the case of Apple Pay but not in the case of PayPal (since merchants can be represented by PayPal’s account); (ii) merchants pay an intermediation fee to PayPal (being the difference between the fee to PayPal and the fee that would be paid through a stand-alone merchant account without PayPal’s involvement) whereas merchants pay no fee to Apple for accepting Apple Pay; and (iii) PayPal captures transaction information (and so, like other aggregators can integrate payments with marketing) but, at least when used a point-of-sale, Apple Pay does not.
It is possible that Apple could enter the aggregation business and, indeed, it acts as an aggregator for its app-developer community (in that these developers ride on Apple’s merchant acquiring account and payment gateway when accepting credit card payments and receive 70% of proceeds). However, for the time being, Apple does not offer an aggregation service for e-commerce retailers and, as such, does not compete with PayPal in its core business. Indeed, except through an app, it is not currently possible to use Apple Pay to pay online; this may change, perhaps through using wireless communication between a TouchID-enabled ‘phone and a desktop computer, but even then and at least initially will likely require the retailer to have its own merchant account.
Valuation and Growth of PayPal
PayPal is not growing operating income which has been flat at ~$475mm over the last three quarters (see Exhibit 1). eBay does not allocate corporate overhead to the payments segment so that it is necessary to make an allocation assumption in order to estimate PayPal’s earnings. Assuming a 25% allocation of the corporate overhead, we generate a (pre-tax) estimate for 2014 PayPal earnings of $1.5bn. Further assuming investors believe an independent PayPal can return to growth (say 12% in 2015), a likely range for the forward earnings multiple is 16-18x (corresponding to a valuation range of $18-20 billion) with the lower-end based on HPY and GPN as compares, and the upper-end (given the opportunity for PayPal to integrate marketing and payments and the growth of PayPal credit) based on ADS as a compare.
Exhibit 1: PayPal Results reported from Payments Segment of eBay
The PayPal challenge is sustaining growth particularly given the goal of broadening the acceptance brand seems less realizable as discussed below. In 2014Q2, PayPal reported a 29% increase in payment volumes (see Exhibit 2) lifted by about 5% by the 2013Q4 acquisition of Braintree which processes ~$10 billion of payments annually. This growth is offset by a 7% decline in the take rate, representing PayPal’s revenue as a proportion of payments volume, because of a shift in volumes to larger merchants (who pay lower rates) and a shift to volumes that are not PayPal-branded such as those generated by Braintree.
Exhibit 2: PayPal Growth
In the core business, PayPal has now penetrated near-80% of eBay merchant accounts so that growth will need to come from off-eBay “merchant services” business; indeed, the eBay business has been in long relative decline (see Exhibit 3) and now accounts for less than 30% of PayPal volumes. An independent PayPal is more likely to be able to access merchants through partnership with companies, such as Amazon, that compete with eBay but the reverse is also true: an independent eBay is more likely to allow merchant clients access to payment services, such as pay-with-Amazon, that compete with PayPal. The latter possibility makes the “arm’s length operating agreements”, planned by eBay CEO John Donahoe for the post spin-off relationship with PayPal, important to valuation.
Exhibit 3: Proportion of PayPal Transactions from eBay (blue line) and Proportion of eBay Revenues from PayPal (red line).
Reducing Cost by Shifting the Funding Mix
PayPal can compensate for a declining take-rate by reducing its operating costs which include payments made to issuers and to the Visa/MasterCard networks (referred to as “transaction expenses”) and the losses for which PayPal is liable on fraudulent transactions where a payment is initiated by a person who is not a valid cardholder. As shown in Exhibit 2 above, transaction expenses are just under 1% of volume and losses just under 30 basis points.
Given we estimate the average cost to PayPal of a Visa or MasterCard credit transaction is 1.5-2.0%, the fact that the transaction expense is less than 1% suggests that as much of half of the volumes are at lower, if not near-zero, cost. One way in which PayPal has lowered its transaction expenses is by encouraging customers to fund PayPal purchases from a bank checking account (using the ACH system as with an electronic check) rather than from a Visa or MasterCard credit account. Mario Shiliashki, now head of US Emerging Payments for MasterCard but previously at PayPal, has commented that ACH funds approximately 20% of PayPal volumes and this proportion has been steady for several years. A second way in which the transaction expense at PayPal is lowered in when customers fund purchases from PayPal balances that are generated from the sale of goods on eBay since these balances are effectively free.
Finally, PayPal lowers transaction expense when customer funds using PayPal credit (previously branded Bill-Me-Later) rather than Visa or MasterCard products or the PayPal-GE private-label card. The current balance on these products is over $4bn (of which $3bn is on PayPal’s balance sheet with PayPal having committed to buy an additional $1bn of balances from GE) so that the spend is relatively low relative to PayPal’s annual volumes of $220bn. However, we expect PayPal credit to increase in importance to PayPal’s funding mix and note that it is the default (and only easily-accessible) credit option available through PayPal in some contexts (e.g. making a purchase on a mobile device from retailers such as B&H).
The Opportunity for PayPal as an Acceptance Brand
While PayPal’s initial value proposition to merchants was around the ease of on-boarding for credit card payments, the firm has now developed a significant buyer community with 150mm active accounts. While less than the 250mm accounts at AMZN and 800mm iTunes accounts, this allows PayPal to make a case to merchants for accepting “Pay with PayPal” as an acceptance brand even if the merchant does not need the aggregation services. A specific argument is that these customers prefer to pay with PayPal because there is no need to deal with the inconvenience and security risk of entering card credentials into multiple merchant sites so that PayPal acceptance can reduce merchant cart-abandonment. The expansion of the PayPal acceptance brand to larger merchants will be important if PayPal is to increase its share of global e-commerce volumes which now stands at 8-9%.
Beyond e-commerce, PayPal has looked to expand it acceptance brand to m-commerce (by providing an API so that retailers can include a pay-with-PayPal button on their mobile apps) and to in-store payments (by allowing customers to access their PayPal accounts at point-of-sale by entering a mobile ‘phone number and PIN on the payment terminal of a participating retailers); through a partnership with Discover, PayPal hoped to expand this “offline” acceptance of its brand to 7 million US merchants but DFS reported this September that “PayPal still hasn’t done their broad rollout launch; we’re the train tracks, they’re the engine, and they have to leave the station”. A potential draw to consumers was convenience services, implemented through the PayPal mobile app, such as order-ahead and skip-the-line but these have not gained early traction and, in any event, can be branded by the retailer through its own mobile app as in the case of PNRA, for example.
If PayPal were successful in establishing its acceptance brand more broadly in e-commerce and offline, there would be an important opportunity to disintermediate Visa and MasterCard by using the alternative funding options discussed above: ACH, PayPal balances from eBay receipts, and private-label credit. However, the opportunity appears less realizable today than, say, a year ago because tokenization means consumers can securely and conveniently pay directly with their Visa and MasterCards (Visa Checkout and MasterCard MasterPass respectively) for browser- and app-based payments. Finally, Paypal’s attempt to extend its acceptance brand to point-of-sale would have been given a boost had it been included in Apple Pay but, likely as a result of insistence from the banks and networks, it was not.
- Some of PayPal’s larger clients have their own dedicated merchant account, rather than using PayPal’s ombudsman account, and so use only the payment gateway.
- In the case of in-app purchases, Apple Pay has to capture transaction information through the “payment sheet” even if only to forward it to Visa and MasterCard.
- The lift in 2013Q4 was due to seasonal factors and the $800mm purchase of Braintree.
- Braintree provides APIs allowing mobile apps to accept payments with clients including Uber, for example.
- PayPal provides volume-discounts so that the standard fee of 2.9% of transaction value falls to 2.5% for merchants with monthly volume above $3,000 and 2.2% for merchants with monthly volume above $10,000.
- Comment from Mario Shiliashki in May 2014