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Can PayPal Pull This Off?


In an Internet market starved for success stories, PayPal (PAPXX) is one of the few upstarts brimming with potential. Still, the Palo Alto (Calif.) company, which handles payments for buyers and sellers on the sites of auctioneer eBay Inc. (EBAY) and other e-commerce players, left the high-tech world agape when it filed paperwork on Sept. 28 for an $80 million initial public offering. The move came just 17 days after hijacked jetliners crumbled the World Trade Center towers and knifed into the Pentagon, killing thousands and pretty much guaranteeing a U.S. recession. Investors are so skittish that not a single company went public in September, the first month without an IPO since Gerald Ford was in the Oval Office.

What gives? PayPal Inc. can't offer a public explanation because of the Securities & Exchange Commission-mandated quiet period for pre-IPO companies. However, interviews with analysts and investment bankers, and an examination of the company's IPO paperwork, shed some light. PayPal isn't desperate for cash. The company boasts $135 million in cash and short-term investments as of June 30--enough to fund the company for two more years.

The likely catalyst for PayPal's IPO bid: It has taken a hefty, if tenuous, lead in handling online payments for consumers and small businesses and is seeking to cement its position before well-heeled rivals can make up ground. PayPal says it has 65% of the market for electronic payments in online auctions, vs. 25% for Billpoint Inc., which is majority-owned by eBay. Billpoint's revenues soared 181% between the first and second quarters of this year, much faster than PayPal's 36% growth--although Billpoint started from a much smaller figure. PayPal, which spent only $45,000 on advertising in this year's first six months and relied on word of mouth to build its customer base to over 10 million accounts, would benefit greatly from the increased visibility and respect that come with a successful IPO.

Another reason for PayPal's IPO filing could stem from its efforts to sell the company. Earlier this year, PayPal executives discussed selling to eBay, Citibank (C), and other companies, but no one would approach PayPal's asking price of more than $700 million, according to analysts and investment bankers. Filing to go public may put pressure on would-be buyers to boost their offers. "They've probably got dual [financing] strategies," says a Wall Street analyst who follows Net-payment companies and insisted his name not be used to protect his relationship with PayPal.

PayPal could end up outsmarting itself. If public investors won't meet the company's asking price, which analysts believe will value the entire company at $700 million to $900 million, PayPal could find itself in a tight spot. Does it drop the price of the IPO and force its private investors to take a haircut? Or does it withdraw the offering and focus on negotiating with potential buyers--albeit from a weaker bargaining position? "I still can't make sense of the [IPO] timing," says Gartner Group Inc. analyst Avivah Litan.

Although its IPO may be a tough sell, PayPal has quite a bit going for it. By providing easy-to-use accounts from which buyers and sellers can instantly exchange money over the Internet, PayPal has become popular among eBay users who had previously been sending checks in the mail and trusting that sellers would deliver the goods as promised. In the past six quarters, PayPal's customer ranks have jumped more than tenfold, to 10.5 million accounts, generating $750 million in transactions. PayPal's take: 2% to 4% of each sale, depending on the amount of monthly business the seller does, as well as 30 cents per transaction.

Even more impressive is the fact that it far outpaces eBay-owned BillPoint on the auction giant's own site. Some 70% of eBay sellers have signed up for PayPal, vs. 30% for BillPoint. PayPal's popularity feeds on itself, as buyers and sellers flock to the payment platform where they can transact with the largest network of people. "PayPal is easy to set up, and it has people using it. That's why the business has worked," says Paul Royka, owner of Appraisal Day Gallery, which does all of its business through eBay auctions and PayPal transactions.

PayPal's financial picture, especially its link to eBay's thriving business, has sparked at least lukewarm interest from institutional investors. This year's first-half revenues of $34.2 million are up from $3.3 million in the same period last year. Although PayPal lost a total of $56.9 million in the past two quarters, $32.8 million of that came from amortization of goodwill, a charge that doesn't cost the company cash. A true viral-marketing company, where word-of-mouth brings in most new users, PayPal spent only 14 cents to add each new customer account in June, down from $6.30 per account last year. "This is a growth story," says senior analyst Paul Bard of Renaissance Capital's IPO Plus Fund. He says he may be interested in a PayPal offering. "We're willing to accept losses if we can be confident in their ability to grow."

PayPal's success has grown out of a number of misfires. The technology was originally developed by a Silicon Valley startup called Confinity Inc., backed by mobile-phone giant Nokia Corp. (NOK). When Confinity introduced the PayPal service in 1999, its focus was on letting people make payments with their mobile phones. But the mobile-commerce market was slow to develop, and Confinity sold out in March, 2000, to X.com, a Palo Alto company that was developing a finance Web site. During 2000, X.com recognized that many larger companies, including E*Trade Group Inc. (ETA) and Yahoo! Inc. (YHOO), were far ahead in building successful finance sites. So X.com founder Elon Musk shuttered its online finance operations, renamed the company PayPal, and concentrated on electronic payments. Today, PayPal's 33-year-old CEO, Peter Thiel, and much of its management team--which averages 32 years of age--are from Confinity.

While the revamped PayPal is generating interest from some investors, it may not get a valuation that it likes. The company raised $90 million in its last round of private funding in March, valuing the whole company at $700 million, according to analysts. But PayPal's quest to hit that mark in an IPO appears to be a stretch. PayPal's publicly traded rivals, including CheckFree Corp. (CKFR), trade at about 2.5 times next year's revenues. Assuming PayPal hits the highest analyst estimates of $100 million in revenues this year and can somehow double that to $200 million next year, the same multiple would put PayPal's valuation at roughly $500 million.

Even that is no sure thing. While the IPO market is rough for any company, it is even worse for Internet upstarts. Only one Net company, Web-hosting startup Loudcloud Inc. (LDCL), has been able to go public this year--down from 129 Internet IPOs in 2000, according to market researcher IPO.com. Loudcloud's stock has plunged 77% since its March offering. Investors are particularly wary of unprofitable companies, and PayPal is not slated to make money for at least two more quarters. "The company lost $170 million last year, and its maximum offering would raise $80 million. Ratios like that always make me a little uncomfortable," says Marc Baum, CEO of IPO.com.

With the interval between the SEC filing for an IPO and the actual offering doubling on average (since the start of 2000) to nearly 140 days, PayPal will likely get at least one more quarter to bolster its numbers before testing investor appetites. With scores of Internet companies searching for any glimmer of hope, PayPal executives aren't the only ones hoping they can pull it off. By Ben Elgin


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