Credit Card and Paypal

In this report, we focus on either aspects of the PayPal vexation. PayPal Basics PayPal is quickly establishing itself as a spheric earnings processor with scale, facilitating approximately $60B in Total salary Volume in 2008. It trunk the largest player foc officed solely on online remunerations however when compared to the heart and soul volume of large global players, such as Visa and MasterCard, PayPals volume remains fairly sm still its $60B TPV was meet all everywhere 1% of the follow volume of commitments processed last year by Visa and MasterCard combined. manikin 1 PayPals Volume Dwarfed by Incumbents in billions 2,000 1, cholecalciferol 1,757 1,548 969 1,000 500 0 Visa ( consultation) Visa (Debit) MasterCard (Credit) character lodge reports, J. P. Morgan estimates. Note Parts of PayPal volume whitethorn be processed using Visa or MasterCards net profit Visa volume excludes Visa europium 406 60 MasterCard (Debit) Pay Pal PayPal is an Established remuner ation Ne cardinalrk and Brand A Rare Commodity PayPal is in rare company, successfully creating itself into a formidable payment network and brand alongside dominant payment brands in Visa, MasterCard, the Statesn Express and Disc over.Payment networks mount at the top of the value chain in payments, collecting high- border fees for facilitating payments from participants seeking access to a network of trusted merchandisers and consumers. PayPal overcame the classic chicken-and-egg dilemma and now has a critical mass of substance abusers in its network, differentiated as a trusted brand for facilitating online payments with the potential to extend its presence into offline opport social unities longer-term.One driver of PayPals exploitation is that, unlike traditional payment methods which developed in an offline world and boast been overlaid onto eCommerce, PayPals platform was built with eCommerce in mind. As such, PayPal has developed tools and risk management measures to orchestrate the unique complexities of handling post-horse not exhibit payments over the net one of the fastest ripening categories in payments. Moreover, PayPal is elegantly structured to simplify the web of connections requ vexationd in a traditional payment system, making it well positioned to penetrate the wee assembly line payments food market. Imran khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com northwesterly the States right liveliness for 26 June 2009 Figure 2 PayPal Simplifies the Payment passage Traditional payment structure merchandiser Payment gate look supplier Merchant depose man-made lake J. P. Morgan. PayPal payment structure Merchant Consumer Consumer Card issuer processor Card-issuing bank Merchant bank Consumer bank We conceptualize the online marketplace, and marketers in particular, benefit from this simplification in some(prenominal)(prenominal) ways Ease of Use.PayPa l gives connoisseurshipally anyone the capacity to select payments, enabling a merchandiser to operate stock-still at an initial scale that would otherwise be uneconomical (i. e. , at that place are no minimum requirements for payment volume in order to use PayPal. ) Higher level of trust. The payments system is not very transparent, and not all aspects were intended for mass use. A trusted central clearinghouse like PayPal tin encourage use of online payments by lowering users safety concerns and face lift their volitioningness to send money online. PayPal Is Differentiated beyond Just Online Commerce PayPal is different from other payment brands (e. g. MasterCard, Visa) in that it is a vertically merged payment provider. In other words, PayPal is a single source provider of payment services. By contracting directly with PayPal Merchant function, small merchants bathroom get all of their payment needs, and do not necessarily need a separate merchant bank account or paymen t gateway services provider. PayPal is gradually expatiateing its presence off eBay by promoting itself as an integrated payment endure along side other payment brands (e. . MasterCard, Visa), supported by PayPals own merchant services plying and alliances with payment vendors like CyberSource (payment gateway) and pass over Paymentech (largest merchant acquirer in the U. S. ). PayPals crossway Offerings for Online Sellers PayPal offers several different products for payment driveance, based on the size and needs of the merchant Email product. This is the offering used largely by little eBay merchants, who receive payments entirely via e-mail, with no situation of their own on which they need to integrate PayPal. Website Payments Standard.This product seizes merchants to place a PayPal only whenton on their site, and when a user is render to check out, the user pullulates the button and is taken to the PayPal site where the actual checkout occurs. 4 Imran caravanse rai (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com normality the States Equity search 26 June 2009 Website Payments Pro. With an incremental $30 periodical fee, the Pro product is break away integrated into a sellers site. The product is intended for small- to medium-size sellers, and requires the seller to be using a compatible hopping cart vendor (most are compatible). Express checkout condemnation. Intended for larger merchants (those already accepting admit Dell and Barnes & Noble). Express Checkout is incremental to the payment acceptance service used by a vendor it gives users an sum totalal checkout option. When a shopper uses Express Checkout, s/he logs into PayPal, and PayPal then forwards address and other info to the merchant. This allows an existing PayPal user to bypass entering personal and shipping information again, even if it is the users first time using the specific merchant. Strong cau seth in dynamic UsersBy continuing to add users crosswise multiple platforms, PayPal has been able to post strong user vexth in recent drags, even despite the slowdown in on-eBay growth and low-single-digit user growth on the eBay site itself Figure 3 PayPal Active User emergence Strong in Recent Quarters Users in Millions 150 100 50 26. 7% 23. 7% 20. 7% 19. 6% 18. 6% 19. 2% 17. 7% 16. 3% 16. 1% 16. 0% 17. 3% 22. 9% 21. 4% 30% 20% 10% 73 70 65 63 60 57 53 55 51 47 49 45 44 0 0% 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 Pay Pal Activ e Accounts Y/Y Grow th Source social club reports, J.P. Morgan Payment Business Basics For a primer on the payments industry, transport see Payment Processing Payments Market Share Handbook published on June 5, 2009 by J. P. Morgans calculating machine Services & IT Consulting analyst, Tien-tsin Huang When a buyer hands cash to a seller, the execution is self-contained. If a faith (or calculate) bug is involved, howeve r, several other parties become involved in the transaction, which we describe below Issuer (Cardholders Bank). Card proceeding start with a card issued by an issuing bank (e. g. Bank of the States, Chase, etc. ) to a consumer.In harm of economics, the bank that issued the consumers credit card takes the purchase price, collects its tack together fee (in the US, 170 -225 bps depending on the type of card), and passes the remainder to the Acquirer (Commonly the Merchants Bank). The acquirer provides merchant services to the merchant, handling all the card and/or electronic payment acceptance needs of the merchant. The merchants acquiring bank 5 Imran caravansary (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com trades union America Equity enquiry 26 June 2009 ccepts the payment, collects a merchant give notice (generally in the 30-50 bps prescribe in the US), and forwards the balance to the seller/merchant. Both t he Issuer and the Acquirer pay a small (7-9 bps each) fee to the Payment Network (see next entry). Merchant acquirer functions allow in Sign up merchants to enable them to accept card payments. Enable merchants to authorize card payments via the network. Pay all network and associated fees for a merchants proceedings Facilitate clearing and settlement of card payments nominate incremental services, e. g. , sending out statements, etc. Payment network (e. g.Visa, MasterCard). As the backbone to the payments industry, networks connect versatile banks that need to process credit card payments with merchants and provide authorization, clearing and settlement services. Networks also set rules and interchange pass judgment (earned by the issuing bank). Payment gateway. In the offline world, the payment gateway is the equivalent of a point-of-sale terminal that accepts the payment type (e. g. credit, debit entry card) and translates it into a format that wad be accepted by the merchant acquirer. In the online world, the gateway generally connects an eCommerce site with the merchant acquirer.PayPal already functions as a Payment Gateway, largely as a result of its acquisition of VeriSigns payment business, which had 144,000 customers when acquired in 4Q05. 6 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Figure 4 Example of a Credit Card Payment Processing Cycle Source J. P. Morgan. How Does PayPal fit in? In most cases, when a PayPal user pays with a credit or debit card, PayPal functions as the Merchant (in Fig. 4).PayPal relies upon its merchant acquirer (usually rise up Fargo) to facilitate the transaction. PayPal the charges the merchant its fees, which on average represent a spread over what the acquirer charges PayPal. In addition, if merchants want, PayPal offers certain merchant acquiring services such as the means to authori ze valid card proceeding and facilitating the clearing and settlement of the transaction done and through the payment network. At this point, we estimate that PayPals merchant acquiring business comprises less than 5% of PayPals TPV. 7 Imran Khan (1-212) 622-6693 imran. t. emailprotected om Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 PayPal Revenue Model Transactional Revenue PayPals business model involves collecting a percentage of revenue from each payment made on the system this percentage has remained in the 3. 75%-4. 0% range since F05. In F08, PayPal collected 3. 86% of TPV as revenue. The following fudge summarizes the contributors to take rate evade 1 Contributors to PayPals Transactional Revenue Take Rate Type Cross-border transactions (CBT) US sellers, non-CBT Intl sellers, non-CBT Payment Gateway Website Payments Pro Source J.P. Morgan estimates % of revenue 35% 33% 25% 3-5% 2-5% footnote PayPal charg es up to 100 bps high rates for CB transactions charges an additional 250 bps for currency spiritual rebirth Sliding scale from 1. 9% based on volume Country-specific pricing generally higher rates than US Acquired from Verisign in 4Q05 limited growth since periodical $30 fee for WPP product Figure 5 Our Estimates of Contributors to PayPals Transactional Revenue Intl rev enue Pay ment Gatew ay Website Pay ments Pro Monthly Fees Cross-border rev enue US rev enue Source J. P. Morgan estimates trade Services and otherwise Revenue Several items are counted as a part of Marketing Services and Other revenue. These include Interest earned on some customer balances. PayPal earns revenue as it receives engross on the balances of some non-US account holders. Note that US customer balances are held in FDIC-insured accounts or in a money market account PayPal does not receive interest on these accounts. BillMeLater interest and fees. Interest and fees earned on existing BML knob balances are classified as Marketing Services and Other revenue. Comparing PayPal Fees to Online CompetitorsPayPals fee structure is standardized to those of its online-only competitors both Google Checkout and Checkout by amazon offer a similar package of fees depending on a merchants monthly gross sales volume Amazon differs in charging a exquisitely different fee level for transactions under $10 as well as minimal cross-border support both buyer and seller must have a US-based financial instrument to use the service. Both Google 8 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 nd PayPal charge roughly (in Googles case, exactly) 1% to a salienter extent for cross-border transactions. See add-in 2 for a summary. As a point of reference, we study offline fees for accepting tease (aka merchant discount rate) average around 1. 9-2. 0% in the U. S. In action of 2009 , Google announced that it would no longer offer a discount on payment process on Google Checkout for Google AdWords advertisers. put off 2 Fees for PayPal, Google, Amazon Remain Similar Transaction Type/Volume Transactions under $10 Up to $3,000 / month Between $3K-$10K Between $10K-$100K $100K and above Cross-border PayPal Same as below 2. % of transaction + 30 cents 2. 5% of transaction + 30 cents 2. 2% of transaction + 30 cents 1. 9% of transaction + 30 cents Varies by currency but 1% extra payments with currency conversion add 2. 5% charge Google Checkout Same as below 2. 9% of transaction + 30 cents 2. 5% of transaction + 30 cents 2. 2% of transaction + 30 cents 1. 9% of transaction + 30 cents 1% of transaction Checkout by Amazon 5. 0% of transaction + 5 cents 2. 9% of transaction + 30 cents 2. 5% of transaction + 30 cents 2. 2% of transaction + 30 cents 1. 9% of transaction + 30 cents US only (seller and buyer must have US-based account)Source conjunction websites PayPals T ransaction salutes Set against the 3. 9% revenue take rate, the business faces two key expense lines that drive its transactional margins transaction processing represent and fraud losses Figure 6 F08 Revenue and Expense get hold ofrs for Aggregate PayPal Payment Volume % of Total Payment Volume, Aggregated across all TPV and Funding Methods 4% 3% 2% 1% 0% 100% of PP rev enue 30. 9% of rev enue 1. 19% 7. 4% of rev enue 0. 28% 61. 8% of rev enue 3. 86% 2. 67% 2. 38% 2. 38% Rev enue Take Rate Processing Ex pense Transaction Losses = Transaction ProfitSource Company reports, J. P. Morgan estimates Processing expense is driven by funding change integrity PayPals positiveness is driven in large part by the undulate of sources from which customers draw coin in order to pay on PayPal. In particular, when customers pay using a credit card, PayPal incurs a world-shatteringly higher cost of finances than when customers fund a purchase using their PayPal balance or an ACH transfer. 9 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009Specifically, PayPal, similar to any merchant that accepts credit separate, is charged a soma of fees (the largest of these is interchange, which is the fee charged by the cardholders bank). For PayPal, we confide these fees amount to 220-250 bps of payments funded with a credit card, with the range representing different types of cards and different geographies (interchange fees are generally higher in the US than across part of the world, including Europe and Australia). Fees are slightly lower, but still in the 150200 bps range, if users shoot a debit card rather than a credit card.By comparison, a payment funded from money already in a users PayPal account carries virtually no cost to PayPal. A payment funded though ACH carries a flat processing fee, usually less than 25c this represents less than 40 bps on a n average PayPal transaction of $62. Figure 7 PayPals Funding desegregate Merchant PayPal collects take rate (1. 9% to as oft as 5%), based on merchant volume and location (signifi screwtly higher if currencies converted) PayPal If funded via If funded from users PayPal balance, cost to PayPal is negligible Credit card, cost to PayPal is 220-250 bps PayPal then functions as Merchant in Fig. above. If funded via If funded via ACH, cost to PayPal is $0. 10-$0. 25 Debit card, cost to PayPal is 150-200 bps PayPals cost of funds becomes more prospering Source J. P. Morgan 10 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Drivers of Funding Mix PayPal allows users to pay with both a credit/debit card and ACH however, PayPal defaults to using an existing balance or ACH, and users must actively select to pay via a credit/debit card every time they use the service.The c ompany has say that customers generally shift toward a more favorable funding intermixture over time. Additionally, as PayPal adds new merchant sites, users of those sites begin with a heavier mix of credit card use. The mix for a merchant site begins to resemble that for PayPal overall as users familiarity with PayPal grows generally, 12-18 months. Additionally, we cerebrate BillMeLater, which is funded entirely through checks and ACH, can help improve funding mix for PayPal down the road. Other Margin Drivers PayPal margins have historically been in the 20% range, excluding corporate expenses.We believe several factors drive the variance mingled with the 60%+ transaction margins and the high-teens overall profitability. Primary among these are Customer service costs. Call centers as well as a word form of employees needed to manage any problems that arise in the payments process. We do not expect these expenses to show important economies of scale as the business continues to grow. Sales and Marketing. As PayPal has invested in growing its Merchant Services business, we believe that segments growth has been fueled by higher Sales conk. When the business matures, we believe there should be some scale economies in Sales. BillMeLater Basics PayPal acquired BillMeLater in 4Q08. The service allows users to request transactional credit, rather than a revolving credit line as is the case with a credit card. BML offers consumers rapid credit decisioning on the infrastructure of less detailed information (date of birth and last four digits of a Social Security Number) than requirement for more traditional financing. The legal age of BMLs revenue is derived from consumer interest payments and fees, as shown below 11 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Figure 8 BillMeLater Economics as of clip of Acquisition % of TPV 12% 10% 8 % 6% 4% 2% 0% 2. 4% Merchant Fees + 6. 5% 3. 6% 2. 9% 3. 4% 2. 1% 4. 1% Cust. Interest Cust. Fees Acquisition Income + Credit follow of Funds = Transaction Profit Serv icing Fraud Loss Source Company presentation, J. P. Morgan estimates Note Cost of funds includes an implied cost of financing consumer receivables transaction expense for processing funds is minimal due to funds being sourced primarily via ACHAt this point, BillMeLaters presence on the eBay site itself remains minimal the company has lay a 3Q09 target for better integration of the business with PayPal, and we believe that, afterwards fuller integration, eBay may choose to drive higher BML brainstorm on the Marketplaces business through, e. g. , promotional or interest-free financing. Complete integration of BML into all aspects of the PayPal solution is expected in 1Q10. Charge-offs BillMeLater reports its net charge-offs as a percentage of the average receivables balance over the course of the quarter in Q10 9 net charge-offs rose to 8. 95%, compared to 8. 5% during the part of the fourth quarter after the acquisition. receivable to the transactional nature of the business, we believe BML has the capacity to continue keeping loan losses at a reasonable level additionally, the company has expressed that it plans to focus on being more fusty with offers of credit in the near term, even at the expense of TPV growth. Nevertheless, we expect charge-offs to continue rising somewhat. Historically, credit card charge-offs have been correlated with the unemployment rate, as seen below. 12 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Figure 9 Historically, Credit Card Charge-offs Rise when Unemployment Rises 10% 8% 6% 4% 2% 0% Q195 Q196 Q197 Q198 Q199 Q100 Q101 Q102 Q103 Q104 Q105 Q106 Q107 Q108 Q109 Unemploy ment Rate Source Federal Reserve, J. P. Morgan Credit Card Net Ch arge-off Ratio piece we believe charge-offs at BML can be managed better, due to the transactional nature of BMLs exposure, we reckon rising unemployment is unconvincing to leave the business untouched. Thus, if unemployment keeps going up, we would expect continued upward drift in charge-offs.PayPals Growth Strategy PayPals original growth engine was the marriage between PayPal and eBay, and the ability to drive higher penetration on the eBay site. We believe the low-hanging fruit in this regard has largely been gathered, but room for growth still exists along several areas of opportunity. 1. Growth Opportunities for PayPal on eBay Continued Geographic Expansion Can Drive Growth One of the biggest factors driving higher PayPal penetration on eBay has been geographic expansion in territories where the business is less mature than in the US.PayPal has had roughly five years of operating history in more than of Continental Europe, compared to nearly a decade in the United States. Table 3 PayPal Penetration as % of Addressable TPV continues to Grow % of addressable TPV Country US Canada United Kingdom Australia France Spain Italy Germany 2004 64% 60% 49% 7% 8% 5% 7% 2% 2008 80% 79% 74% 47% 43% 37% 36% 15% 2011(E) 84% 82% 81% 72% 61% 57% 56% 39% Comment Could see addl boost from BML Penetration already nearly 60% see below In terms of online act, much of continental Europe is following in the footsteps of the UK, but several years behind.Penetration nearly doubled in F08 alone Source eBay Presentation, J. P. Morgan estimates We believe the 2008 take in in Australia, where PayPal penetration went from under 40% to nearly 60% over the course of a year, is broody of eBays capacity to grow penetration via rule changes the company rolled out rules mandating most sellers to offer PayPal as an option in 2008, and penetration grew by more than half over the course of the year. 13 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009Figure 10 Australia Demonstrates PayPals Capacity to rapidly Boost Penetration 60% 50% 40% 30% Q108 Q208 Q308 Q408 Source Company presentation, J. P. Morgan estimates Additionally, several continental European countries have seen growth roughly in parallel since the rollout of PayPal in much of continental Europe in summer 2004. We See Limited Opportunity for Domestic on-eBay Growth Having already achieved notable levels of penetration on established sites, we dont think PayPal will see significant additional pluss in on-eBay penetration from current levels, especially in the US.However, as eBay increases the amount of buyer protections and begins to offer credit through BML, we think the percentage of GMV that is addressable by PayPal can rise. Figure 11 PayPal volume as a % of Addressable GMV, 2008 GMV in $B 30 20 $29B $24B 10 0 79% 41% US Source Company reports, J. P. Morgan Pay Pal Non-Pay Pal In ternational One additional way to increase penetration on the site is for the company to offer increased incentives for sellers and buyers to choose PayPal as the payment method.These incentives can take the form of carrots (coupons, higher levels of protection) or sticks (e. g. , rules making other forms of payment more difficult to accept). PayPal has continually increased buyer protections on eBay for uses who pay with PayPal, with the levels rising from $1,000 to $2,000 in January 2007 and going up again to offer unlimited coverage in June 2008. We think offering higher levels of buyer protection but only when paying with PayPal remains a useful lever for increasing the penetration of PayPal on the eBay site. 14Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 PayPal on eBay Challenges Weak Marketplaces Growth Will Negatively move TPV Growth In line with recen t declines in GMV, the percentage of PayPals TPV that is driven by on-eBay activity has been steadily declining in recent quarters, with 3Q08 having represented the first quarter in PayPals history that saw a majority of TPV come from the Merchant Services part of the Payments business.Figure 12 On-eBay TPV Continues to Decline as a dower of Total 70% 60% 50% 40% 30% 20% 10% 0% 62% 58% 56% 56% 54% 51% 49% 49% 46% Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109 Percentage of TPV deriv ed on eBay Source Company reports, J. P. Morgan estimates As eBay has struggled to improve GMV growth and faced headwinds from FX, the on-eBay portion of TPV has seen nominal phrase growth turn negative in recent quarters, as shown in the chart below set for FX the last two quarters have seen on-eBay TPV grow 5% and 3%, respectively.Figure 13 On-eBay TPV Growth Continues to shut away Off-eBay TPV Y/Y change 80% 60% 40% 20% 0% -20% 1Q07 50% 19% 57% 62% 66% 61% 57% 49% 35% 26% -7% 18% 18% 17% 17% 19% 12 % -3% 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 On-eBay TPV, Y/Y Source Company reports, J. P. Morgan estimates Off-eBay TPV, Y/Y We are currently modeling GMV to shrink by 14% in F09, returning to slight growth in F10 with a 1% rise. Even when looking only at non-Vehicles GMV, our model calls for an 11% decline this year, followed by a 1% growth in the next year.While we think eBay has taken many correct steps in improving the agonisticalness of its Marketplaces segment, we remain concerned that the competitive environment 15 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 will make it difficult for eBay to reaccelerate growth and reclaim market carry on in future years. Additionally, we believe the shift to a frictionless eCommerce model is driving buyers to choose fixed-price formats over an auction approach.As this has the effect of moving from a home eBay con trols into a much more competitive, multi-channel environment, we think it creates an additional headwind to growth. Cultural Headwinds in Some Geographies In addition to the above, two specific geographic regions have presented challenges for growing PayPal penetration In Germany (and Austria, combined, estimated at 15% of GMV), the majority of online payments are made using bank transfers, and PayPal has had limited success displacing this system. However, as Table 3 (above) indicates, PayPals penetration in Germany has been rising.In Korea (we estimate 5% of GMV), where eBay recently announced plans to acquire GMarket and combine it with its current auction. co. kr site, the predominant mode of payments is using escrow accounts. As in Germany, we believe penetration can rise over time as users become more comfortable with PayPal. Given the challenges in these two areas, which comprise approximately one fifth of eBays GMV, we believe it could be difficult for eBay to go signific antly past the 70% penetration threshold in the next five years. Bottom Line We see $36B in F11 on-eBay TPVBased on our current model of F10 GMV (excluding Vehicles) of $43B, and an assumption of accelerating GMV growth to 10% Y/Y in F11, we think PayPals oneBay TPV could hit $36B in F11 (implying a 6% 3-year CAGR), with a range of $33B-$40B depending on more or less favorable assumptions. Figure 14 On current trends, on-eBay portion of PayPal would contribute $36B in F11 TPV On-eBay TPV, $ in billions 40 35 30 25 2008 2009E Optimistic Current Model 2010E Pessimistic 2011E Source Company reports, J. P. Morgan estimates 16 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 2. Growth Opportunities for PayPal off eBay PayPals growth through increasing penetration of off-eBay online commerce has been a key component of the businesss growth in recent years. We think the co mpany retains significant runway to add customers. Historically, Focus on Smaller Sellers Due to its roots as a solution for payments on the eBay platform, PayPal has generally seen a higher penetration among little and mid-size sellers.This is partly due to the fact that PayPal has no fixed costs to a merchant, whereas accepting credit cards carries fixed costs. For a seller generating $100K in annual revenue, a $60$70/month cost for accepting credit cards amounts to nearly 1% of sales. Table 4 Economics of PayPal compelling for SMB market PayPal Setup fees Monthly Service Fee Monthly Gateway Fee Transaction fee Monthly Minimums $0 $0 $0 1. 9%-2. 9% + $0. 30 None Merchant Processor $0-$ccc $20-$50 $10-$30 2. 0%-3. 0% + $0. 10-$0. 50/transaction $0-$30Source Company reports, processor websites and J. P. Morgan estimates Figure 15 Payment Solutions P a y m e nt s o lu tion s D is a d va n ta ge s re la tiv e to P ay P al Buyer S eller C an n ot b e tra cked L im ite d p rote cti on ag a in st lo ss/th eft R estricte d to virtu a l w orld L im ite d p ro te ction a g a in st lo ss/th eft R e stricte d to virtu a l w orld S lo w se ttle m en t/fu lfillm e n t tim e C ost/tim e of w ritin g che cks S lo w se ttle m en t tim e F ra ud riskC red it C ard Joh n Q Pu b lic 5012 345 6 7890 1234 S ecu rity unce rta in ty of sm a ll b usin e ss site C re d it lim its In te re st co sts H ig h tra n sa ctio n fee s p ro hib itive fo r sm a ll m erch a n ts R e qu ire s m e rcha n t b ank a ccoun t F ra ud risk (card no t p rese n t) P ro ce ssin g tim e /co st S e tup co sts W ire (e . g. , W e ste rn U n io n ) F ee s U su a lly re qu ire s p h ysica l visit to ve n do r L im ite d a cce p ta n ce Source J. P. MorganPenetration among Large Businesses Small, but Growing Whereas smaller sellers were PayPals bread-and-butter in the early days, the greater part of online commerce now occurs at larger sellers. This is especially legitimate when one incl udes online travel, a category PayPal has pursued aggressively whereas eCommerce has a fairly long tail of sites, the great majority of online travel is transacted at the large providers and OTAs. 17 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009Table 5 Penetration at top 50 online merchants, by geography As of March 2009 Country USA UK Germany France Australia Penetration 42% 28% 16% 36% 60% Source Company presentation and J. P. Morgan estimates Internet Retailer Data PayPals Penetration Higher with Smaller Merchants Based on data from Internet Retailer, we estimate that 26% of the total sales volume on the top 50 online retailers in F08 came on sites that accept PayPal. Consistent with PayPals past focus on smaller sellers, PayPal penetration among sites outside the top 50 is 39%, nearly 1. x the penetration among the top 50. Figure 16 Smaller Merchants More Lik ely to Accept PayPal % of internet retailers accepting PayPal, weighted by 2008 online sales Internet Retailer Top 50 I. R. Top 50, ex cluding Amazon Rest of I. R. Top 500 (51-500) 0% Source Internet Retailer, J. P. Morgan estimates 26% 33% 39% 10% 20% 30% 40% Note Internet Retailer does not include travel sites in its rankings The following table summarizes PayPals presence (including previously existing BillMeLater relationships) on the top 50 retail sites as ranked by Internet Retailer. 8 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Table 6 26% of Revenue at top 50 US eCommerce Sites is Addressable by PayPal 2008 Sales in $ millions Site Amazon. com Inc. Staples Inc. Dell Inc. Office Depot Inc. Apple Inc. OfficeMax Inc. Sears Holdings Corp. CDW Corp. smartegg Inc. Best Buy Co. QVC Inc. SonyStyle. com Walmart. com Costco Wholesale Corp. J. C. Penney Co. Inc. HP floor & Home Office inclose Circuit City Stores Inc.Netflix Inc. Victorias Secret Target Corp. Systemax Inc. L. L. Bean Inc. Macys Inc. Williams-Sonoma Inc. spreadhead Inc. Direct HSN Inc. Zappos. com Inc. Amway orbiculate Overstock. com Inc. Avon Products Inc. 1-800-Flowers. com Inc. Nordstrom Inc. Buy. com Inc. Redcats USA The Neiman Marcus Group Inc. Musicians Friend Inc. Blockbuster Inc. PC Connection Inc. Toys R Us Inc. Cabelas Inc. BarnesandNoble. com Inc. bookworm Inc. The Home Depot Inc. VistaPrint Ltd. Saks Direct Nutrisystem Inc. Peapod LLC drugstore. com Inc. Nike Inc. Kohls Corp.Verticals nonuple Office Supplies Computers Office Supplies Computers, Digital Sales Office Supplies incision Store Computers Computers Electronics Multiple Electronics Multiple Multiple Department Store Electronics Electronics Video Rental Apparel Multiple Electronics Apparel Department Store Home Apparel Multiple Apparel Multiple Multiple wellness & Beauty Flowers Apparel Multiple Mult iple Department Store Musical Equipment Video Rental Computers Toys debauched Goods Media Media Home Office Supplies Department Store Food Groceries Health & Beauty Apparel Department Store 2008 Online Sales $19,170 $7,700 $4,830 $4,800 $3,642 $3,084 $2,693 $2,600 $2,100 $2,015 $1,993 $1,828 $1,740 $1,700 $1,500 $1,497 $1,414 $1,365 $1,333 $1,209 $1,072 $1,044 $1,040 $1,033 $1,030 $1,016 $1,014 $904 $834 $754 $750 $686 $657 $617 $565 $531 $526 $516 $500 $497 $466 $455 $437 $401 $381 $376 $373 $367 $366 $356 PayPal? No No Yes No No Yes No No Yes No No Yes Yes No No Yes No No No No Yes No No No No No Yes Yes Yes Yes Yes No Yes No No Yes No No Yes No Yes No No No No No No Yes No No BML?No No No No Yes Yes No Yes Yes No Yes No Yes No No No No No No No Yes No No No No No Yes Yes Yes No Yes No Yes Yes No Yes No No Yes Yes No Yes No No No Yes No Yes No No Comment Ended BML relationship after PayPal Acquisition Could leverage BML relationship Could leverage BML relationship Site now owned by Systemax, a PayPal customer Could leverage BML relationship Could leverage BML relationship Could leverage BML relationship Could leverage BML relationship Source Internet Retailer, J. P. Morgan estimates 19 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Off-eBay market share of 4. % in F08 We estimate that PayPals $29. 5B Merchant Services TPV in F08 (excluding BML) represented 4. 2% of the combined volume of eCommerce and Travel spend in that year. Our current estimates call for that number to rise to nearly 4. 9% of the total in F09. Table 7 J. P. Morgan eCommerce and Travel Market estimates $ in billions crime syndicate Off-eBay eCommerce Travel Total off-eBay volume PayPal off-eBay TPV PayPal penetration F07 311. 4 271. 9 583. 3 19. 9 3. 4% F08 379. 0 329. 2 708. 2 29. 5 4. 2% F09E 412. 0 342. 2 754. 2 37. 0 4. 9% F10E 490. 8 405. 1 895. 9 50. 2 5. 6% F11 E 561. 4 458. 0 1019. 3 64. 2 6. 3% Source Company reports and J. P.Morgan estimates We estimate that combined global online spend on eCommerce and Travel will exceed $1 trillion in F11. By our estimate, PayPals Merchant services would need to access over 6. 0% of this volume in order to hit the low end of the target $4B-$5B PayPal revenue range indicated by the company. 3. Growth through BillMeLater We see several key effects on PayPal of the 4Q08 acquisition of BillMeLater. In the near term, we think the addition could hurt profitability, firearm longer-term, we believe it can become a contributor to PayPal growth both on- and off-eBay. Minimal near-term TPV bear on. BML accounted for 1. 2% of total 1Q09 TPV.As such, we think it is important to note that the current impact of BML on PayPal results is likely to be somewhat small. Near-term growth likely slow. The company has state that it intends to be very conservative in its approach to the tradeoff between growing BML volume and maintaining healthy credit metrics. Given the current environment, we believe this will significantly damp growth in BML TPV through at least the end of F09. Integration, portfolio losses to impact profits. PayPals segment margin in the last two quarters was 500 bps lower than in the same two quarters a year ago. The company has attributed this decline to the impact of integrating BML as well as charge-offs related to the units loan portfolio.Medium-term, synergies become possible. Once consumer credit regains a measure of health, we think the company will begin to use BML as an additional tool to grow business, e. g. , by offering financing to incentivize users to pay with PayPal both on and off eBay. Target is convenience shoppers, not the underbanked. We believe eBay sees BML as an additional feature (or convenience) to attract higher-quality customers, rather than as a tool to expand its progress among customers who do not otherwise have access to credit. This approach ap pears consistent with the tradeoff storied above of slower growth in exchange for better credit metrics. 20Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Auto financing unlikely to be priority. As noted above, Vehicles interchange on eBay have been largely beyond PayPals reach up to now. We think eBay sees BMLs sum of money expertise in transactional credit for smaller amounts than involved in a car purchase. A significant expansion of the business to include auto financing seems unlikely in the near to medium term. tinct on margins temporary. eBay expects segment margins to revert to historical trends as BML is incorporated into PayPal more completely (e. g. the company expects BML to be integrated into the PayPal wallet by 3Q additionally sales teams for BML and for Merchant Services are being unify to give clients a single touch point). BillMeLater C an Improve Funding Mix We think the impact of BillMeLater in the longer term will be felt most strongly on PayPals funding mix BML does not accept credit cards, and as such faces a lower transaction funding cost than the PayPal business as a whole. As such, any portion of TPV that shifts from the historical mix of funding sources to BML will help lower PayPals cost of funds. Assuming, conservatively, that PayPal manages the business to have a similar take to the rest of PayPal, we estimate that each 1% shift of TPV onto BillMeLater would drive 2 bps forward motion in funding cost.Thus, if BML were to grow to 4% penetration of our mid-point F11 scenario of $100B in TPV, it would drive 8 bps improvement in funding cost an incremental $80M contribution to the bottom line, or 5c of EPS. Table 8 Sensitivity Analysis EPS Boost from Lower Transaction Cost as BML Penetration Rises TPV in $B, BML as a % of TPV, EPS impact in $ TPV BML % 87. 1 100. 5 113. 8 Source J. P. Morgan estimates 1% $ 0. 01 $0. 01 $0. 01 2% $0. 02 $0. 02 $0. 03 3% $0. 03 $0. 04 $0. 04 4% $0. 04 $0. 05 $0. 05 5% $0. 05 $0. 06 $0. 07 Credit Cards Pain Could Be PayPals Gain Recently, the dramaturgy and Senate passed bills restricting certain practices in the credit card industry. We believe that such steps could have several points of impact on PayPal.Crucially, if these rule changes make credit card issuers less generous toward consumers (e. g. , lower profitability drives issuers to lower the levels of rewards for credit card use), PayPal could benefit from funding mix improvement, as the incentives for customers to fund their accounts with credit cards, vs. debit or ACH, would be reduced. Further, we believe that, should credit card issuers try to recapture profitability with less consumer-friendly rules as well as more frequent fees, the quality of the user experience for credit cards will erode, making consumers incrementally more likely to use PayPal. 21 Imran Khan (1-212) 622-6693 imran. t. emailprotected om Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 4. Growth Opportunity Expanding Merchant Acquiring Business We believe PayPal currently has two strategic growth opportunities going forward. The company can drive greater adoption of the PayPal solution by continuing to establish PayPal as a brand for online payment, alongside incumbent players such as Visa and MasterCard. Alternatively, PayPal can attempt to improve its payment economics by becoming a scale merchant acquirer. This would allow PayPal to capture the 30 bps on card transactions that we estimate it currently gives up to its acquirer.Finally, PayPal may attempt to skate along the knife-edge between the two above strategies, maintaining relationships with large acquirers such as Chase Paymentech while at the same time functioning as an acquirer for its smaller client base. PayPal as a Brand Chase Paymentech, the largest merchant acquirer in th e U. S. and the largest processor of e-Commerce transactions, offers PayPal as an integrated payment option alongside well known names like Visa and MasterCard. As such, Chase Paymentech clients have the option to advertise acceptance of PayPal as a payment type. According to Chase Paymentech, clients that accept PayPal (in addition to credit cards) commonly see an increase in sales. We raft this as an important distinction that PayPal has potential to be a powerful brand off eBay.We believe PayPals recent stated focus on larger merchants suggests this is the more likely strategic direction for the company, as PayPal may not want to jeopardize its status as a partner to the large acquirers, which make it easier for enterprise-scale businesses to include PayPal as one of several payment choices. Can PayPal Become a Scale Merchant Acquirer? In our view, PayPal also has the potential to become a scale merchant acquirer, which could enhance its off-eBay presence, especially among smal ler and mid-size merchants. As a merchant acquirer, PayPal would handle all of the card processing needs of a merchant, including directly processing other brands like Visa and MasterCard.We believe PayPal can offer very competitive rates to small merchants (who often pay heavy miscellaneous fees to acquirers), given its scale, allowing it to deepen relationships with merchants and potentially handle offline transactions as well. Smaller merchants (especially the 87% of US merchants with annual card acceptances under $100K) tend to pay a much higher spread to their acquirer. Whereas such merchants account for 10% of credit card volume, we believe they represent as much as $2. 5B in merchant acquirer revenue more than 1/3 of the total revenue in the US merchant acquirer business. We think PayPals historical strength among smaller sellers can be an advantage in accessing this market. Chase Paymentech offers PayPal as an integrated payment option for its clients.Chase Paymentech was th e largest merchant acquirer in the U. S. in 2008 with 22. 5% market share 22 Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Table 9 Top Ten US Merchant Acquirers, 2008 $ in billions Merchant Acquirer Chase Paymentech First Data BofA Merchant Svcs Elavon Fifth Third Processing Solutions Global Payments Wells Fargo Merchant Services Heartland Payment Systems First National Merchant Solutions RBS WorldPay Source The Nilson Report. V/MA volume $567 $293 $283 $181 $165 $93 $91 $75 $51 $48 Market share 22. % 16. 9% 11. 2% 7. 2% 6. 5% 3. 7% 3. 6% 3. 0% 2. 0% 1. 9% As noted above, PayPal currently partners with Wells Fargo when it comes to handling non-PayPal branded transactions. One concern about a PayPal entry into the acquirer market would be whether it could successfully maintain its relationships with the other acquirers who currently offer PayPal as an option, and who would come to view PayPal as a more direct competitor. How Much is PayPal Worth? Combining the outlook outlined above, we believe PayPal TPV will reach $100. 5B in F11 though somewhat more pessimistic or optimistic projections for the units growth yield a range of $87B-$114B.At the midpoint, our estimate is for a 19% 3-year CAGR in Total Payment Volume. Figure 17 On current trends, TPV on pace for just over $100B in F11 Total PayPal TPV, $ in billions 125 100 75 50 2008 2009E Optimistic New Model 2010E Pessimistic 2011E Source Company reports, J. P. Morgan estimates Assuming the PayPal take rate remains just below 3. 9% (and assuming healthy growth in PayPal Marketing Services and Other revenue in F11), our TPV estimate would result in $4. 1B in PayPal revenue. On the profitability side, we believe PayPal is likely to see segment margins shrink to 17. 2% for F09 due to the continuing integration of BML by comparison, segment 23 Imran Khan (1-212) 622-6693 imran. t. emailprotecte d omTien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 operating margin as reported by the company was 20. 0% in F08. We think PayPal segment margins can expand back to above 18% by F11. Figure 18 plane section income could reach $785M in F11 PayPal segment operating income, $ in millions 1000 800 600 400 2008 2009E Optimistic New Model 2010E Pessimistic 2011E Source Company reports, J. P. Morgan estimates Based on our scenarios for PayPal F11 results, we believe the unit is likely to achieve approximately $450M in Net income. At a 20x multiple, this would yield a $9B valuation. Table 10 Scenario Analysis to Get to a PayPal value in billions except where indicated On-eBay TPV Off-eBay TPV Total TPV Revenue Segment Margin Unallocated Corporate Costs Pro Forma Operating Income ($M) Tax Rate Net Income F11 Earnings Multiple PayPal Value Source Company reports, J. P. Morgan estimates Worse Case 33. 0 54. 2 87. 1 3. 57 17. 5% 4% 482 25% 361 16 5. 8 Average Case 36. 3 64. 2 100. 5 4. 09 18. 8% 4% 603 25% 452 20 9. 0 Better Case 39. 6 74. 3 113. 8 4. 61 20. 0% 4% 737 25% 553 24 13. 3 Comparative Valuation of PayPal Unit We believe it is instructive to look at several comparables when it comes to valuing PayPal. Specifically, Visa and MasterCard provide payment networks, while Global 24Imran Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America Equity Research 26 June 2009 Payments is a pure-play merchant acquirer, functioning in much the same way as PayPal does by providing an on-ramp for merchants into the payment system. Table 11 Comparative Valuation for PayPal $ in billions PayPal $67B 11% 1% $2. 70B 13% 17. 2% Some credit risk due to BML Visa $2,702B -1% 60% $6. 94B 6% 52. 9% None 20. 8 17. 1 15. 4 MasterCard $1,759B -9% 34% $4. 97B 0% 43. 2% None 15. 7 13. 4 11. 7 Global Payments N/A ($93B in F08) N/A 4% $1. 59B 10% 19. 2% None 18. 4 15. 8 12. 5 CyberSource N/A N/A