The Starting Line: PayPal faces long IPO odds

These analysts, none of whom want to be named, are questioning the motives behind the PayPal IPO since it looks like a throwback from the dot-com bubble in 1999.

PayPal's service helps small businesses or individuals handle payments. A payer deposits money in a PayPal account from a credit card, bank account or existing PayPal account. The receiver can leave the money in the account, where it earns interest at money-market rates. This person can also transfer funds to a separate bank or a PayPal bank card, or PayPal can cut him or her a check.

PayPal's market is swarming with competitors, including the likes of eBay, Yahoo and Citigroup. The company has never turned a profit, and doesn't foresee black ink anywhere in the future. And like those companies that launched IPOs in the late 1990s, it expects investors to pony up as much as $80.5 million to buy a stake.

Simply put, PayPal, which filed for an IPO Sept. 28 and hasn't set a price range, is a long shot, analysts say.

So why would PayPal file for an IPO when the stock market is struggling? The company declined to comment, citing an IPO quiet period, but that hasn't deterred any speculation about its prospects. Part of that speculation derives from the fact that PayPal has plenty of cash. As of June 30, the company had $134 million in cash and short-term investments--more than some public companies have.

"PayPal believes that rather than choose the alternative of letting the downturn of (venture capital) funding slow down their strong progress, it makes sense to try the approach of filing an S1 now," said James Van Dyke, research director at Jupiter Media Metrix.

The eBay connection
According to filings with the Securities and Exchange Commission, PayPal recorded $19.9 million in sales for the fiscal quarter ended June 30, up from $2.1 million in the year-ago quarter. Its losses dropped from $47.8 million in the year-ago quarter to $27.6 million.

PayPal's revenue comes from several sources, the main one being the transaction fees charged to its business customers who receive more than $100 a month. Revenue from its gross merchant sales came to $16.3 million, or almost 82 percent of total revenue for the most recent quarter. It also charges fees on international accounts and on its ATM/debit cards.

Right now, about 70 percent of PayPal's business comes from auctions, "particularly eBay" auctions, according to PayPal's prospectus. It's far and away the most popular electronic payment method on eBay, dwarfing the auction company's in-house competitor, Billpoint.

But that could change. While eBay has so far been content to allow PayPal to operate on its site, it's not required to do so. Indeed, eBay recently ran into some flack after it required sellers participating in a charity auction to use the Billpoint service.

eBay does have plenty of incentive to force the issue. Steve Weinstein at Pacific Crest Securities estimates that eBay makes $1.25 per auction from Billpoint, and that every point of market share it gains in 2002 would be equal to about $7.3 million in revenue. But PayPal remains far more popular. While approximately 23 percent of auctions on eBay during the second quarter offered Billpoint as a payment method, only about 3.6 percent of those actually ended up using the service.

And eBay recently filed a shelf registration that gives it up to $1 billion worth of stock to play with; the company said at the time that it might use the shares for acquisitions. eBay declined to comment on its relationship with PayPal.

"If eBay wanted a slam dunk with Billpoint they'd buy them," said one Wall Street analyst who asked to remain anonymous. "eBay's position on their site is: We want to offer multiple options. But Billpoint has been gaining traction."

Fierce competition
Billpoint, which is partially owned by Wells Fargo, isn't the only competition PayPal faces. Yahoo offers the Yahoo PayDirect service, and Citigroup is pitching its c2it product.

The services backed by banks are used to dealing with payment methods and the troubles that go with them, but fraud has been a problem for PayPal.

If a credit card is used to make a payment, and the charge is disputed or fraudulent, the credit card company assesses a "chargeback" to PayPal, meaning the company ends up eating the cost. Between July and October, a "significant fraud episode" cost the company $5.7 million, 64 percent of all chargebacks for the year. In fact, MasterCard International ended up fining PayPal an unspecified amount due to its high chargeback rate.

Credit card payments pose another problem for PayPal. Namely, they're very expensive because the company pays the transaction fee that is normally incurred by the merchant. And in the most recent quarter, credit card payments accounted for just over 50 percent of payment volumes, according to the company's prospectus.

Ideally, the company would like customers to pay using funds from existing PayPal accounts, or at the very least use wire transfers from bank accounts. But customers can get extra security through credit cards, and they accrue reward points by using them.

That's something a competitor backed by a credit card company wouldn't have to worry about. Indeed, such companies may just be waiting for the right time to jump into the market.

"I'm confident (the credit card companies) have person-to-person offerings they could issue tomorrow and are just holding off to avoid cannibalizing themselves," Van Dyke said. "The great thing about that model is that it represents very trusted brands."

There are some points in PayPal's favor that would make it an attractive purchase. For one thing, it's got the network effect going--that is, the more people who use the service, the more desirable it becomes. And potential competitors face their own problems: eBay runs the risk of turning off its own customers, while credit card companies are wary of cannibalizing their own sales--by encouraging their merchants and customers to use a new method instead of traditional credit cards.

And while there have been many attempts to set up electronic payment methods, PayPal appears to be one of the few that's actually been able to gain real popularity in the United States.

"Any company in alternative payments is (taking) a risk but also falls into (a) high-risk, high-return category," Van Dyke said. "A small number of companies are going to make a killing."

But even with that potential, selling PayPal to the public may still be an uphill battle.

"They're supposedly in the right place, and the industry is moving more toward the model that the business represents," said David Menlow, president of IPOfinancial.com. "This is going to be difficult to get past the (IPO) investor that has been run through the wringer."