Selling kicked off in January when the online auction giant announced charge increases of as much as 60% for merchant sellers. The ensuing uproar from users prompted eBay (nasdaq: EBAY - news - people ) to scale back, but the damage was done. A week after the announced price hikes, eBay reported fourth-quarter earnings below Wall Street estimates for the first time in two years, and issued downbeat earnings guidance. Coming off a 2004 gain of 80%, shares have tumbled 44% so far this year through Wednesday's close.
Online payment unit PayPal could save the day. Acquired by eBay in 2002, PayPal accounted for 21% of 2004 revenue and was the vehicle for 74% of auction payments, compared with just 8% revenue and handling 44% of auction payments in 2002.
J.P. Morgan Securities noted in November that PayPal was the payment method for 40% of the U.S. auctions on eBay before the acquisition. "As such, we believe there is potential for faster growth rate in the international business, and we believe the company is still in the early stages of developing the PayPal offering in Europe," the firm said.
Both eBay and PayPal declined to be interviewed for this article.
PayPal President Jeff Jordan said at a recent investor conference that PayPal's greatest potential for growth lies outside the eBay platform and in international expansion. PayPal has tried to attract outside merchants and international customers by increasing time limits for fraud claims and lowering cross-border fees for EU countries.
Gauging PayPal's risks is tricky. It is a low-margin, high-volume business with average transaction fees hovering around 3% and may be facing potential regulatory issues. Prior to PayPal's planned IPO in early 2002, Louisiana regulators said the company could not conduct business in the state until licensed as a money transmitter. Today, PayPal holds similar licenses or waivers to do business in about 40 states and is licensed as an "electronic money institution" in the UK and, more recently, Australia.
Eric M. Jackson, former head of product marketing at PayPal and author of The PayPal Wars, said, "PayPal may look like a bank on the outside but they only provide payments and auxiliary services to their customers as a courtesy." Customers' funds are deposited in FDIC-insured bank accounts or an opt-in money market fund run by Barclays. PayPal also offers "buyer protection" lines of credit through a unit of General Electric (nyse: GE - news - people ) and offers a branded debit card via JPMorgan Chase (nyse: JPM - news - people ) unit Bank One.
Jackson said PayPal had discussed the banking model but didn't pursue it because of the enormous amount of capital required. PayPal likely won't revisit the issue. "Frankly, PayPal is so good at facilitating payments they don't need to become a bank," Jackson said.
EBay nips regulatory issues in the bud, Jackson said, pointing to PayPal's 2002 encounter with New York State Attorney General Eliot Spitzer's efforts to stop the funding of online gambling accounts. In September eBay announced it would fine customers who violate the acceptable use policy, which prohibits using PayPal for gambling pornography, and prescription drugs.
Most recently, PayPal and the major credit card firms abandoned online purchases of tobacco. It could also be viewed as a cost-cutting measure since PayPal's volume of credit card transactions--more than half of all payments--makes it vulnerable to increases in interchange fees. "PayPal's financial success will remain highly sensitive to changes in the rate at which its senders fund payments using credit cards," eBay said in its latest annual report. It remains to be seen how great of an impact MasterCard's fee hike, which took effect this month, will have on future earnings.
Scott Kessler, an S&P Equity Research analyst, said potential competition from well-heeled financial institutions remains a wild card. "There are a lot of massive financial institutions that have an interest in the segment," he said. "Of course, more relevant is that they have an interest in spending a heck of a lot of money in making inroads."
Also, Amazon.com (nasdaq: AMZN - news - people ) may be mulling the adoption of a similar service to reduce bad debt expenses from credit card transactions, according to a February research report from Bear Stearns. Amazon.com's head of operations Jeff Wilke "noted that opportunities such as an automated clearing house solution or a PayPal-like service could have the potential to reduce this cost overtime and there is potential to move in that direction in the future, though he stressed that using PayPal itself was not part of Amazon.com's plans." Amazon.com declined to comment.
Perhaps more critical than potential competition, Kessler said, is the firm's push for small- and medium-sized businesses outside of eBay. The hunt for growth markets is all the more critical for eBay as its sensitivity to retail cycles gradually increases. Kessler said, "The fourth quarter is more important to eBay now than it was a couple years ago, particularly in the retail context."
"Once they have a slow quarter the stock is going to get massacred," predicted Andrew Whinston, a professor at the University of Texas at Austin and director of the Center for Research in Electronic Commerce. "It'll really drop like a bomb, in my opinion. I'm not going to say they're going to disappear tomorrow but they just aren't growing as much." Whinston said he thinks Google (nasdaq: GOOG - news - people ) has drawn away investor attention. "Google is a big growth story and it's innovating all the time. EBay was last year's, or several years' ago, growth story."
