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Offline Payments: The Next Big Opportunity For eBay's Paypal

 February 27, 2012 10:49 AM

One of the biggest and transformative opportunities that exist in front of PayPal, the electronic payment division of eBay, Inc. (NASDAQ:EBAY), is offline payments, and its recent partnership with Home Depot, Inc. (NYSE:HD) is the first step in that effort.

Last month, PayPal announced its first foray into in-store "cloud based" payments via a partnership with Home Depot, with around 50 stores in the San Francisco area adopting the new technology. As per the deal, shoppers at select Home Depot stores can pay with PayPal through cashiers or at self-checkout kiosks by entering their mobile numbers and PINs. Shoppers can also swipe their PayPal cards and enter their PIN numbers at checkout.

Both firms have started the pilot project on Jan. 6 at five Home Depot stores and then expanded to more than 50 retail locations throughout the country.

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Right now, almost all of PayPal's $120 billion total payment volume (TPV) comes from online transactions, which are derived from only around 5 percent of global retail sales plus other payments. The other 95 percent that is offline is handled primarily by credit and debit card transactions and cash.

But, how far the new payment option would succeed remains a question as the current options are working quite well and customers are finding no big need to switch their payment options.

"Our initial thoughts are that the technology actually works pretty seamlessly, which is a big positive. However, in its current form (which we expect to evolve), the technology creates little incentive for a consumer to chose PayPal over existing payment options," RBC Capital Markets analyst Ross Sandler wrote in a note to clients.

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If PayPal needs to succeed, it should offer large incentives in the form of loyalty points or coupons to woo customers. 

"If the consumer does not have large incentives to use PayPal, we don't expect the new payment choice to gain significant market share," Sandler added.

In addition, PayPal needs to create consumer awareness about the new payment option with significant marketing and promotions by both the merchant and by PayPal before it becomes an household payment method of choice. 

"The biggest negative in the Home Depot experience was that there was no way for the consumer to know it existed as an option until checkout. We expect PayPal to expand this effort with Home Depot over time," Sandler added.

The analyst expects that the merchant discount fee for in-store payments is well below PayPal's current company average take-rate as card-not-present transactions are generally more expensive compared to card present, and the offline payment space is generally more competitive, especially with larger merchant accounts. 

Sandler assumes that PayPal is earning a 1–2 percent take-rate per transaction for in-store payments compared to the current average of 3.7 percent across all of PayPal's online business. At 1–2 percent take rate and much lower transaction margin, in-store payments would represent PayPal's lowest-margin model compared to on-eBay and Merchant Services online payments, but over time, increased volume is expected to make up for the lower margin.

Meanwhile, in-store transactions should have upward trajectory for transaction margin from initial levels. Sandler expects that PayPal's transaction margin is around 40–50 percent for in-store compared to the 64.8 percent reported for the fourth quarter for core PayPal.

From a financial standpoint, the TPV earned via in-store payments is likely to cut average take rate and transaction margin, but the company said it should be accretive to operating margin over time.

The company said that though the in-store transaction margin is expected to be lower than core PayPal overall, the in-store payment operating margin could surpass the core online payments segment margin (currently 24.7 percent) over the long term.

Initial operating expenses and sunk development costs should compress operating margin in the trial and initial ramp-up phases. PayPal is investing in additional sales force and significant R&D expenses, but as the TPV increases and the instore model matures, segment margins are expected to be higher than core PayPal over time.

In addition, Paypal needs to compete with new entrants such as Google, which is going all out to promote its Google Wallet service into stores through a partnership with Citi and MasterCard.

Recently, online mobile payments company Boku also launched a new online payment service that enables customers to pay via any mobile phone. The service will be offered by wireless carriers, with Boku running the system in the background.



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