EBay's Profitable Pal

PayPal—and other electronic payment services—are wooing more and more consumers and merchants, and becoming the quiet stars of e-commerce

by Catherine Holahan

A disappointing revenue forecast and news that longtime eBay (EBAY) CEO Meg Whitman would soon retire overshadowed the real star of the e-commerce company's Jan. 23 earnings report: PayPal. The business purchased by eBay in 2002 handled almost $50 billion in payments during the year, up more than 30% from the prior year. Along the way, PayPal generated $1.9 billion in processing fees for eBay, giving company executives plenty to crow about on their conference call with analysts. "PayPal is a fabulous business, it's growing fast and has the kind of accelerating momentum we love to see," said CEO-designate John Donahoe. Whitman called the company, in short, "a gem."

PayPal's success mirrors the growing popularity of electronic payment services. About 14% of online payments in the U.S. are made with credit-card alternatives, such as PayPal, Google (GOOG) Checkout, and Bill Me Later, according to a recent report by Javelin Strategy & Research. PayPal and peers have a long way to go before matching the scale of long-established payment services such as Mastercard (MA), which processed $577 billion in the third quarter alone, but the upstarts' share of online payments will only increase. By 2012, roughly 30% of U.S. online transactions will go through such services, according to the Javelin report.

Why not just put it on a Visa? Experts point to three main drivers for alternative payments: concern over fraud risk, growth in merchant participation, and fear of, or lack of access to, credit cards. Use of online payment services is likely to accelerate in the coming year, says Bruce Cundiff, Javelin's research director. "PayPal is gaining this following and that is essential," he says. "In five years, we forecast that PayPal will represent more than 10% of online transactions."

Credit-Card Alternatives

Identity theft has grown more than 50% since 2003 (BusinessWeek.com, 11/21/07) as people release more sensitive information online, according to Gartner (IT). To protect users, online payment alternatives won't pass a credit-card or checking account number to a merchant. Instead, PayPal and others typically deliver funds through an intermediary account that in turn draws on a bank or credit account. The payment service can receive funds from the underlying account; the merchant cannot.

Alternative payment services typically report lower rates of fraud than major credit-card companies. Of the total amount that PayPal processes, it takes a fraud loss on 0.26% of transactions, or a fraction of the typical fraud loss rate of about 1% for online merchants. And on Jan. 28, eBay acquired Fraud Sciences, an Israeli provider of online fraud detection tools, for $169 million in hopes of further reducing its vulnerability to criminals. "We know why buyers want to use PayPal is for security," says PayPal spokesperson Amanda Pires. "So we need to advance and stay ahead of fraudsters."

Another reason online payments are gaining greater traction is that more retailers and other merchants are using them.