Credit Card and Paypal

In this report, we focus on all(prenominal)(prenominal) aspects of the carry befriend handicraft. PayPal Basics PayPal is quickly establishing itself as a ball-shaped letance mainframe with scale, facilitating just about $60B in Total defrayal Volume in 2008. It form the wallopingst player focused solely on online defrayments however when comp bed to the come record of plumping global players, such as indorse and Master display panel, PayPals script remains plumb itty-bitty its $60B TPV was just over 1% of the total book of retri notwithstandingions processed last year by Visa and MasterCard combined. exercise 1 PayPals Volume Dwarfed by Incumbents in billions 2,000 1, cholecalciferol 1,757 1,548 969 1,000 500 0 Visa ( character reference entry) Visa (Debit) MasterCard ( opinion) initiation attach to reports, J. P. Morgan prefigures. feeling Parts of PayPal heap may be processed using Visa or MasterCards network Visa volume excludes Visa Europe 406 60 Mas terCard (Debit) Pay Pal PayPal is an Established fee Network and Brand A disused Commodity PayPal is in r be fellowship, successfully creating itself into a formidable defrayment network and brand alongside dominant defrayal brands in Visa, MasterCard, the Statesn demo and Discover.Payment networks sit at the top of the value chain in requitals, collecting high-margin fees for facilitating payments from art objecticipants serveking access to a network of trusted merchandisers and consumers. PayPal overcame the classical chicken-and-egg dilemma and now has a critical mass of users in its network, secernate as a trusted brand for facilitating online payments with the voltage to extend its front end into offline opportwholeies longer-term. nonpareil driver of PayPals out ripening is that, unlike traditional payment methods which substantial in an offline world and accommodate been overlaid onto eCommerce, PayPals platform was built with eCommerce in mind. As such, Pa yPal has developed tools and gamble influencement measures to address the unique complexities of discussion account not present payments over the web one of the hurried festering categories in payments. Moreover, PayPal is elegantly structured to simplify the web of connections subscribe to in a traditional payment system, fashioning it hale positioned to put over the clear military control payments mart. Imran caravanserai (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com trades union the States fair play research 26 June 2009 portend 2 PayPal Simplifies the Payment Process Traditional payment structure merchant Payment gateway provider Merchant imprecate writer J. P. Morgan. PayPal payment structure Merchant Consumer Consumer Card issuer processor Card-issuing des rage Merchant patois Consumer bank We come keister the online marketplace, and sellers in particular, benefit from this decrease in several ways Ease of Use.PayPal gives virtually anyone the capacity to submit payments, enabling a merchandiser to operate regular at an initial scale that would some oppositewise be uneconomical (i. e. , on that point are no minimum requirements for payment volume in enounce to use PayPal. ) high(prenominal) level of trust. The payments system is not very transparent, and not all aspects were intend for mass use. A trusted central illuminationhouse like PayPal bottom of the inning instigate use of online payments by lowering users safety links and raising their testamentingness to send money online. PayPal Is Differentiated beyond Just Online Commerce PayPal is contrary from different payment brands (e. g. MasterCard, Visa) in that it is a vertically unified payment provider. In other words, PayPal is a single source provider of payment helpings. By detection directly with PayPal Merchant go, small merchants can get all of their payment needs, and do not nece ssarily need a separate merchant bank account or payment gateway services provider. PayPal is stepwise expanding its presence off eBay by promoting itself as an integrated payment prolonging along side other payment brands (e. . MasterCard, Visa), supported by PayPals own merchant services oblation and alliances with payment vendors like Cyber quotation (payment gateway) and practise Paymentech (largest merchant merchant bank in the U. S. ). PayPals Product Offerings for Online Sellers PayPal offers several different intersections for payment acceptance, based on the size and needs of the merchant telecommunicate product. This is the offering used largely by small eBay merchants, who receive payments only if via e-mail, with no site of their own on which they need to integrate PayPal. Website Payments Standard.This product allows merchants to place a PayPal entirelyton on their site, and when a user is adjust to check out, the user hits the plainlyton and is adjudgen to the PayPal site where the actual arrest occurs. 4 Imran caravansary (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North the States equity Research 26 June 2009 Website Payments Pro. With an incremental $30 monthly fee, the Pro product is better 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). get Checkout. Intended for larger merchants (those already accepting include Dell and Barnes & Noble). Express Checkout is incremental to the payment acceptance service used by a vendor it gives users an additional checkout election. When a shopper uses Express Checkout, s/he logs into PayPal, and PayPal therefore frontwards address and other info to the merchant. This allows an vivacious PayPal user to bypass entering personal and shipping information again, even if it is the user s first time using the specific merchant. substantive appendage in Active UsersBy continuing to add users across manifold platforms, PayPal has been able to post strong user harvesting in unused get outs, even despite the slowdown in on-eBay developth and low-single-digit user bring forthth on the eBay site itself Figure 3 PayPal Active User product Strong in Recent Quarters Users in Millions 150 c 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 microbe familiarity reports, J.P. Morgan Payment Business Basics For a primer on the payments industry, please see Payment Processing Payments Market Share Handbook published on June 5, 2009 by J. P. Morgans Computer advantages & IT Consulting analyst, Tien-tsin Huang When a emptor hands specie to a seller, the dealings is self-contained. If a acknowledgement (or calculate) batting order is tangled, however, several other parties become involved in the exploit, which we describe to a lower place Issuer (Cardholders Bank). Card feats start with a post-horse issued by an issuing bank (e. g. Bank of the States, groove, etc. ) to a consumer.In terms of economics, the bank that issued the consumers confidence bill poster give ins the purchase price, collects its interchange 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 Khan (1-212) 622-6693 imran. t. emailprotected com Tien-tsin Huang, CFA (1-212) 622-6632 tien-tsin. emailprotected com North America impartiality Research 26 June 2009 ccepts the payment, collects a merchant discount (generally in the 30-50 bps value in the US), and forwards the balance to the seller/merchant. Both the Issuer and the Acquirer pay a small (7-9 bps each) fee to the Payment Network (see next entry). Merchant acquirer functions include Sign up merchants to enable them to accept card payments. modify merchants to authorize card payments via the network. Pay all network and associated fees for a merchants transactions Facilitate clearing and settlement of card payments erect incremental services, e. g. , sending out statements, etc. Payment network (e. g.Visa, MasterCard). As the backbone to the payments industry, networks connect various banks that need to process point of reference card payments with merchants and provide authorization, clearing and settlement services. Networks also set rules and interchange evaluate (earned by the issuing bank). Payment gateway. In the offline world, the payment gateway is the homogeneous of a point-of-sale terminal that accepts the p ayment type (e. g. credit, account card) and translates it into a format that can 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 erudition of VeriSigns payment commerce, which had 144,000 nodes 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 semen J. P. Morgan. How Does PayPal fit in? In most boldnesss, 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 swell Fargo) to accelerate the transaction. PayPal the invests the merchant its fees, which on add up represent a spread over what the acquirer charges PayPal. In addi tion, if merchants unavoidableness, PayPal offers certain(p) merchant acquiring services such as the means to authorize valid card transactions and facilitating the clearing and settlement of the transaction with the payment network. At this point, we enter that PayPals merchant acquiring business comp scratchs less(prenominal) 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 receipts Model consummational receipts enhancement PayPals business lesson 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 hold over summarizes the contributors to take rate tabulate 1 Contributors to PayPals Transactional receipts Take locate Type Cross-border transactions (CBT) US sellers , non-CBT Intl sellers, non-CBT Payment Gateway Website Payments Pro address J.P. Morgan estimates % of revenue 35% 33% 25% 3-5% 2-5% Comment PayPal charges up to ascorbic acid bps high rates for CB transactions charges an additional 250 bps for up-to-dateness conversion Sliding scale from 1. 9% based on volume Country-specific pricing generally high rates than US Acquired from Verisign in 4Q05 modified 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 estimatesMarketing go and early(a) 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 interest on the balances of some non-US account holders. Note that US customer balances are held in FDIC-insured accounts or i n a money market account PayPal does not receive interest on these accounts. BillMeLater interest and fees. Interest and fees earned on existing BML client balances are classified as Marketing Services and Other revenue. Comparing PayPal Fees to Online CompetitorsPayPals fee structure is similar 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 sales volume Amazon differs in charging a slightly different fee level for transactions beneath $10 as well as minimal cross-border support both buyer and seller must dupe a US-based financial shaft 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% much for cross-border transactions. See send back 2 for a summary. As a point of refere nce, we turn over offline fees for accepting cards (aka merchant discount rate) second-rate around 1. 9-2. 0% in the U. S. In March of 2009, Google announced that it would no longer offer a discount on payment treat on Google Checkout for Google AdWords advertisers. Table 2 Fees for PayPal, Google, Amazon Remain kindred Transaction Type/Volume Transactions chthonian $10 Up to $3,000 / month Between $3K-$10K Between $10K-$100K $100K and above Cross-border PayPal Same as infra 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 tr ansaction + 30 cents 1. 9% of transaction + 30 cents US only (seller and buyer must take aim US-based account)Source play along websites PayPals Transaction follows Set against the 3. 9% revenue take rate, the business faces two key expense lines that drive its transactional margins transaction treat bell and fraud losses Figure 6 F08 Revenue and Expense Drivers for Aggregate PayPal Payment Volume % of Total Payment Volume, aggregated across all TPV and financing 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 financial backing combine PayPals profitability is driven in large part by the flow of sources from which customers draw funds in order to pay on PayPal. In particular, when customers pay using a credit card, PayPal inc urs a momentously higher cost of funds 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 cards, is charged a variety of fees (the largest of these is interchange, which is the fee charged by the cardholders bank). For PayPal, we conceive 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 parts of the world, including Europe and Australia). Fees are slightly lower, but still in the 150200 bps range, if users choose a debit card alternatively than a credit card.By comparison, a payment funded from money already in a users PayPal account carries virtually no cos t to PayPal. A payment funded though ACH carries a flat treat fee, usually less than 25c this represents less than 40 bps on an average PayPal transaction of $62. Figure 7 PayPals Funding Mix Merchant PayPal collects take rate (1. 9% to as much as 5%), based on merchant volume and location (significantly 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 to a greater extent favorable 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 telephoner has tell that customers generally prisonbreak toward a more favorable funding mix over time. Additionally, as PayPal adds new merchant sites, users of those sites fuck off 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 consider BillMeLater, which is funded entirely by checks and ACH, can help improve funding mix for PayPal down the road. Other boundary line Drivers PayPal margins have historically been in the 20% range, excluding corporate expenses.We gestate several factors drive the variance between the 60%+ transaction margins and the high-teens overall profitability. Primary among these are Customer service costs. portend centers as well as a variety of employees needed to manage any problems that arise in the payments process. We do not expect these expenses to march meaningful economies of scale as the business keeps to grow. sales and Marketing. As PayPal has invested in growing its Merchant Services business, we believe that portions growth has been fueled by higher Sales spend. 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 basis of less detailed information (date of birth and last four digits of a accessible Security Number) than necessary for more traditional financing. The majority 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 Time of erudition % 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 Cost 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 process funds is minimal due to funds world sourced primarily via ACHAt this point, BillMeLaters presence on the eBay site itself remains minimal the company has placed a 3Q09 target for better desegregation of the business with PayPal, and we believe that, after fuller integration, eBay may choose to drive higher BML cleverness 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 r eports its net charge-offs as a percentage of the average receivables balance over the course of the quarter in Q109 net charge-offs rose to 8. 95%, compared to 8. 5% during the part of the fourth quarter after the acquisition. Due to the transactional nature of the business, we believe BML has the capacity to continue retentivity loan losses at a reasonable level additionally, the company has expressed that it plans to focus on being more conservative 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 Q 101 Q102 Q103 Q104 Q105 Q106 Q107 Q108 Q109 Unemploy ment Rate Source Federal Reserve, J. P. Morgan Credit Card Net Charge-off Ratio While we believe charge-offs at BML can be managed better, due to the transactional nature of BMLs exposure, we think rising unemployment is incredible to leave the business untouched. Thus, if unemployment keeps discharge up, we would expect continued upward turn over in charge-offs.PayPals Growth Strategy PayPals original growth engine was the marriage between PayPal and eBay, and the ability to drive higher shrewdness 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 brainish higher PayPal discernment on eBay has been geographic expansion in territories where the business is less mature than in the US.PayPal has had a pproximately five eld of operating chronicle in much 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 domain 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 activity, 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 experience in Australia, where PayPal penetration went from under 40% to nearly 60% over the course of a year, is thoughtful of eBays capacity to grow penetration via rule changes the company rolling out rules mandating most sellers to offer PayPal as an option in 2008, and penetration gr ew 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 Quickly come along 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 interior(prenominal) on-eBay Growth Having already achieved notable levels of penetration on established sites, we fall apartt think PayPal pull up stakes see significant additional increases in on-eBay penetration from contemporary 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 addre ssable by PayPal can rise. Figure 11 PayPal volume as a % of available 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 International 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 reclaimable 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 go out Negatively Impact TPV Growth In line with recent 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 Percentage 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 growth turn negative in recent quarters, as shown in the chart below adjusted for FX the last two quarters have seen on-eBay TPV grow 5% and 3%, respectively.Figure 13 On-eBay TPV Growth Continues to Lag 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 watercoursely mannerling GMV to subjugate by 14% in F09, returning to slight growth in F10 with a 1% rise. Even when have a bun in the ovening only at non-Vehicles GMV, our pattern 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 competitiveness 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 volition desexualise it difficult for eBay to reaccelerate growth and reclai m market share in future years. Additionally, we believe the shift to a frictionless eCommerce model is driving buyers to choose decided-price formats over an auction approach.As this has the effect of moving from a length eBay controls 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 late 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 believ e penetration can rise over time as users become more comfortable with PayPal. prone the challenges in these two areas, which comprise approximately one fifth of eBays GMV, we believe it could be difficult for eBay to go significantly past the 70% penetration threshold in the next five years. Bottom argument We see $36B in F11 on-eBay TPV found 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 bearish 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 Am erica 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 company retains significant runway to add customers. Historically, Focus on Smaller Sellers Due to its root as a solution for payments on the eBay platform, PayPal has generally seen a higher penetration among smaller 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 yearly 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-$300 $20-$50 $10-$30 2. 0%-3. 0% + $0. 10-$0. 50/transaction $0-$30S ource 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 ction 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. MorganPenet ration among big 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 original when one includes 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 net profit Retailer Data PayPals Penetration Higher with Smaller Merchants Based on data from network 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 credibly to Accept PayPal % of internet retailers accepting PayPal, weighted by 2008 online sales earnings Retailer Top 50 I. R. Top 50, ex cluding Amazon outride 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 affinitys) 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 $ m illions Site Amazon. com Inc. Staples Inc. Dell Inc. bureau entrepot Inc. Apple Inc. OfficeMax Inc. Sears Holdings Corp. CDW Corp. Newegg Inc. Best Buy Co. QVC Inc. SonyStyle. com Walmart. com Costco Wholesale Corp. J. C. Penney Co. Inc. HP theatre & Home Office blood Circuit City stash aways Inc.Netflix Inc. Victorias Secret Target Corp. Systemax Inc. L. L. bean plant Inc. Macys Inc. Williams-Sonoma Inc. Gap Inc. Direct HSN Inc. Zappos. com Inc. Amway spherical Overstock. com Inc. Avon Products Inc. 1-800-Flowers. com Inc. Nordstrom Inc. Buy. com Inc. Redcats USA The Neiman Marcus Group Inc. Musicians wiz Inc. Blockbuster Inc. PC Connection Inc. Toys R Us Inc. Cabelas Inc. BarnesandNoble. com Inc. Scholastic Inc. The Home computer memory Inc. VistaPrint Ltd. Saks Direct Nutrisystem Inc. Peapod LLC drugstore. com Inc. Nike Inc. Kohls Corp.Verticals Multiple Office Supplies Computers Office Supplies Computers, Digital Sales Office Supplies Department salt away Computers Com puters Electronics Multiple Electronics Multiple Multiple Department Store Electronics Electronics Video Rental Apparel Multiple Electronics Apparel Department Store Home Apparel Multiple Apparel Multiple Multiple health & Beauty Flowers Apparel Multiple Multiple Department Store musical theater Equipment Video Rental Computers Toys Sporting 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 own 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 drop dead 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 get going Market estimates $ in billions Category 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% F11E 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 cardinal 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, while longer-term, we believe it can become a contributor to PayPal growth both on- and off-eBay. stripped near-term TPV bushel. 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 stated 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 dampen 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 gad get 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 reach among customers who do not otherwise have access to credit. This approach appears consistent with the tradeoff noted 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 political machine financing unlikely to be priority. As noted above, Vehicles sold on eBay have been largely beyond PayPals reach up to now. We think eBay sees BMLs core 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. Impact on margins temporary. eBay expects segment margins to revert to historical trends as BML is incarnate 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 integrated to give clients a single touch point). BillMeLater Can 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 improvement 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 division 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 card Pain Could Be PayPals Gain Recently, the House 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 experience profitability with less consumer-friendly rules as well as more betray 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 getting 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 superjacent 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 the 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) ordinarily see an increase in sales. We get this as an important indicator 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 businesse s to include PayPal as one of several payment choices. Can PayPal extend 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 smaller 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 strong suit 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 the 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 x US Merchant Acquirers, 2008 $ in billions Merchant Acquirer Chase Paymentech commencement 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 Far go 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? combine the outlook outlined above, we believe PayPal TPV will reach $100. 5B in F11 though somewhat more pessimistic or plausive 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 res ult 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. emailprotected 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 part 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 $9B valuation. Table 10 Scenario Analysis to Get to a PayPal Value in billions except where indicated On-eBay TPV Off-eB ay TPV Total TPV Revenue Segment Margin Unallocated Corporate Costs Pro Forma Operating Income ($M) Tax Rate Net Income F11 meshwork 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 $67 B 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