Inside the 21st Century Wallet: eBay and PayPal

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When online auction giant eBay (NASDAQ: EBAY) was founded in 1995, few people believed that the Internet would become the future of shopping. Few realized that the 28.8k text-based world known as the Internet would evolve into the broadband, wireless omnipresent cloud of today, seamlessly connecting our computers, smartphones and tablets.

Fast forward 18 years. Brick and mortar retail giants - such as Best Buy, JCPenney and Sears - now struggle to stay profitable. Consumers are increasingly using their smartphones and tablets to scan store items, turning their stores into giant, unprofitable showrooms.

Meanwhile, e-commerce giants eBay and Amazon are sitting pretty, enjoying comfortably brisk sales volume without being hampered by real estate and inventory issues.

Just as Amazon disrupted the tablet and e-book markets with its seminal Kindle Fire tablet, eBay is now looking forward into the future of mobile payments.

eBay is no longer content simply being an online auction site. It wants to replace your entire wallet or purse, as an all-in-one digital wallet, and that reality may be closer than you realize.

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A narrow earnings beat

eBay reported its fourth quarter earnings earlier this month, narrowly topping analyst estimates. The San Jose, California-based company reported adjusted earnings of 70 cents per share, or $571 million, on revenue of $4 billion. That represented a 62% decline in earnings per share and an 18% increase in revenue.

The dramatic year-on-year decline in earnings is nothing to be alarmed about, since earnings in the prior year quarter were highly inflated from the sale of Skype to Microsoft for $8.5 billion in 2011. Adjusted earnings topped forecasts by a cent, while revenue was squarely in line with the consensus.

Historically, the stock has sold off after earnings (both positive and negative), but this time the stock rallied, for one major reason - PayPal.

The power of PayPal

Without a doubt, PayPal - which eBay acquired a decade ago - has evolved into eBay’s most important asset. The digital payment system, which allows users to pay each other through e-mail addresses, is eBay’s preferred payment method, and is also increasingly accepted by other e-commerce retailers.

Just take a look at PayPal’s fourth quarter numbers:

<table> <tbody> <tr> <td> <p><span><span><span><strong>PayPal Revenue </strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Revenue Growth (Y-O-Y)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>New Users</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Total Users</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Total PayPal Transactions</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span>$1.54 billion</span></span></span></p> </td> <td> <p><span><span><span>24%</span></span></span></p> </td> <td> <p><span><span><span>+5 million</span></span></span></p> </td> <td> <p><span><span><span>123 million</span></span></span></p> </td> <td> <p><span><span><span><span>700 million</span></span></span></span></p> </td> </tr> </tbody> </table>

Those five million new users represent the largest increase in PayPal users in eight years, as a testament to the increasing need for instant digital payments.

PayPal’s revenue is generated by service fees to merchants, similar to the ‘swipe fees’ of payment processors Visa (NYSE: V) and Mastercard (NYSE: MA). PayPal’s mobile application has been downloaded onto over 120 million devices since its inception, and mobile payments accounted for 10% of PayPal’s total payments in 2012.

PayPal’s offline expansion

To expand its offline presence, PayPal users are given the option of signing up for a PayPal card, which works just like a normal debit card at participating stores.

eBay recently inked a deal with Discover Financial Services (NYSE: DFS), which will allow PayPal to be accepted anywhere Discover credit cards are accepted, starting this spring. This newly forged alliance could also help boost Discover's tiny market share (by purchases) of 3%, which is dwarfed by Visa's 57% and Mastercard's 25%.

In addition, eBay signed deals with 23 retailers, including Home Depot, RadioShack, Barnes & Noble and Abercrombie & Fitch, which will allow PayPal to be directly accepted as a form of payment.

In addition, eBay has been testing out several experimental payment systems at several locations. At one Jamba Juice location in Emeryville, California, customers can place their orders by smartphones, pay by PayPal, and pick up their orders without waiting. eBay has also created a new payment system with NCR, which allows smartphone users to pay the bill at participating restaurants with their smartphones using PayPal, eliminating the need to wait for the check.

CEO John Donahoe clearly declared his ambitions in digital payments, stating, “Our intent is to drive PayPal to be the digital wallet.”

The digital wallet

eBay now has two routes of generating revenue - regular e-commerce sales from its eBay website - and using PayPal to serve both its e-commerce and brick and mortar interests. This allows the company to compete with while treading into Visa and Mastercard’s territory. These major credit card companies already recognize this growing threat, and Discover has already allied with eBay. Could a deal with American Express be that far behind?

Another major variable is NFC (near field communication) technology, which enables smartphones to become digital payment devices. Although NFC chips are considered ‘bleeding edge’ technology that lacks the proper infrastructure to immediately become popular, the exponential growth of smartphones and tablets may eventually force retailers to adopt this standard. In which case, traditional credit and debit cards will rapidly become obsolete, and PayPal will be able to exploit its head start in electronic payments to become an industry leader.

Visa and Mastercard have already launched their own NFC services - PayWave and PayPass, respectively - in order to defend against PayPal. PayWave and PayPass were initially added to traditional credit cards, and has since been added on as a feature for many smartphones for "contactless" payments.

Donahoe estimates that eBay and PayPal will process $20 billion in transactions each in fiscal 2013. If his vision of a complete “digital wallet” comes to fruition, then that number could easily double or triple in the next few years.

Bottom line

Shares of eBay have soared nearly 80% in the past twelve months. Yet it still trades at a discount to its e-commerce peers, with a forward P/E of 17.5 and a 5-year PEG ratio of 1.28. Like its rival, eBay has been a revolutionary force in the e-commerce revolution, which puts it on the winning side of the battle of the retailers.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends, eBay, and Visa. The Motley Fool owns shares of, eBay, and MasterCard.You can follow Leo Sun on Twitter at for more investing ideas.

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