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scott devittStifel Nicolaus analyst Scott Devitt published a report Friday on Google's (NASDAQ:GOOG) recently launched Google Checkout. Highlights follow:

Highlights:

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* Yesterday Google launched its payment processing service, Google Checkout. Google Checkout will offer a streamlined checkout process and offer integration with Google's advertising program. In terms of pricing, Google will charge merchants a 2% commission on a sale, plus 20 cents per transaction using its payment service. For every $1 merchants spend on AdWords, they can process $10 in sales through Google Checkout at no charge.

* We believe Google's offering is broadly competitive with eBay/PayPal and Amazon. We also find it strategically relevant to Yahoo! and MSN given the possible impact to ROI that could occur with the discount Google plans to give merchants using the system. It is important to note that Google's offer to merchants discounts existing AdWords by 21% from current levels. This could create share shift toward Google and more ad spend but a possible scenario could also include competitors matching and driving moderately lower industry margins over time. Excluding the incentives and possible share shift, we estimate that Google's gross margin on this business is less than 1%.

* We have Buy ratings on Google, Yahoo! (NASDAQ:YHOO) , and eBay (NASDAQ:EBAY) and are recommending allocating near-term capital in that order. We continue to believe the revenue opportunities within large cap Internet companies more than offset higher capital spending and a more competitive environment.

In-depth analysis:

Yesterday, Google launched it payment processing service, Google Checkout. Google Checkout will offer a streamlined checkout process and offer integration with Google's advertising program.

Yesterday, Google officially launched its payment processing service, Google Checkout. Originally dubbed Google GBuy, the system is designed to make the checkout process for buyers smoother, faster and more secure. Consumers choosing to use Google Checkout need to enter their credit card information only once, as it is then stored by Google, removing the need for shoppers to repeatedly enter the same information at every online shopping venue. In addition, shoppers can keep track of their purchase history, including orders and shipping details, in one place. Another benefit of the service is that it conceals the buyer credit card number and provides reimbursement for unauthorized purchases, as well as offering the choice to consumers whether or not to keep email addresses confidential. Merchants who offer the service will have a shopping cart icon displayed next to their AdWords advertisements or a Google Checkout option on their site.

For merchants, this service has the ability to drive better converting traffic to their sites. A quicker, easier and safer experience for consumers can translate into more sales. In terms of pricing, Google will charge merchants a 2% commission on a sale, plus 20 cents per transaction using its payment service. For every $1 merchants spend on AdWords, they can process $10 in sales through Google Checkout at no charge. Several service providers have integrated the service within their platforms, including GSI Commerce and ChannelAdvisor as well as stores including Starbucks, Timberland, Buy.com, Zales, Ace Hardware, and several others.

We note that PayPal has over 105 million accounts. Unlike PayPal, Checkout does not have access to bank account information, offer money market rates on held funds, or allow for international sales (yet). Google Checkout is simply a repository for credit card information securely stored. If users are manually entering credit card information on a merchant's site, it is unlikely that they were utilizing PayPal for that purchase anyway. While this service may not be the "PayPal killer" many imagined, we do think that it can pose a threat to PayPal volume over time. It is uncertain as of yet if eBay will allow its seller to use Google Checkout, but we doubt it. PayPal offers a different type of service, one that will not be replaced by Google Checkout in its current form.

Google Checkout is enabled for transactions with Visa, MasterCard, American Express and Discover, and is currently running a promotion with the Citi card. The service is currently open to all U.S. merchants, whether or not they utilize AdWords, and Google is currently working to make the service available to merchants internationally.

We believe Google's offering is broadly competitive with eBay/PayPal and Amazon. We also find it strategically relevant to Yahoo! given the possible impact to ROI that could occur with the discount Google plans to give merchants using the system. It is important to note that Google's offer to merchants discounts existing AdWords by 21% from current levels. This could create share shift toward Google and more ad spend but a possible scenario could also include competitors matching and driving moderately lower industry margins over time. Excluding the incentives and possible share shift, we estimate that Google's gross margin on this business is less than 1%.

We believe the initial impact to Google's income statement will be minimal in the near term. However it is worth noting that Google will be running this business at 1% gross margin (revenue of 2% and $0.20 less credit card processing costs of 1.9% and $0.15). Also, Google plans to give its merchants who utilize Google Checkout $10 of free payment processing for each $1 of AdWords spent. Using a $1,000 AdWords budget would derive $10,000 of free payment processing which would cost Google $210 to give away (ASP of $75, 133 transactions, at 1.9% and $0.15 per transaction) leaving Google with 21% less in AdWords revenue than it would have received if the merchant was not on the program. It is possible that the incentives in place could cause the merchant to spend more on AdWords, it could also bring new advertisers, and it could cause advertisers to bid prices to levels that mitigate the negative impact of incentives. The investor should also keep in mind that Google's checkout initiative could also serve to lower margins in the search industry.

Thus a successful Google Checkout could be very positive for consumers and merchants but create a drag on the profits of the industry, the natural result of competition. We believe it is quite possible that both Microsoft and Yahoo! cut deals with PayPal to offer a similar platform with incentives in their own respective platforms. Finally, it is possible that the incentives offered by Google could be removed over time; however, doing this could also cause a merchant uprising given that the incentives are not promoted as being short-term in nature.

eBay/PayPal

Last year PayPal generated over $28 billion of payment volume of which over $8 billion came outside of the eBay platform. PayPal has more 105 million accounts worldwide so is quite a formidable competitor for Google Checkout. The Google offering offers an incentive to merchants, which we estimate to be in the range of 21% off of existing AdWords to use Google Checkout. A merchant views additional payment offerings as giving more solutions to its consumer so we would expect decent merchant adoption. We believe buyers have some incentive to use Google Checkout due to the integration of shipment tracking, order history, feedback, and rebates (in isolated instances). However, we think the buyer side of the equation could be the more difficult to achieve scale for Google. eBay could be disadvantaged if it does not opt-in to Google's offering as it could reduce eBay's relevancy in the paid search results compared to other merchants that may opt in due to changing click-through rates (still, we do not expect eBay to opt-in to the service). The Checkout product is outstanding although we are yet unsure that it impacts PayPal materially, at least not in its initial form.

Amazon

Amazon's (NASDAQ:AMZN) business is about trust, pricing, selection, and convenience. Google Checkout offers trust by managing a consumers credit card transactions without releasing data to the merchant, pricing by possibly lowering merchant costs that could be passed to the consumer, selection by aggregating several merchants under one common payment thread, and convenience as it relates to the information stored within the users Google Checkout account. To be sure, we believe the impact to Amazon is fairly limited given the core advantage within the fulfillment end of its business that offers unparalleled value to the consumer both in terms of pricing and the expediency of delivery.

Yahoo!/Microsoft

We believe that Google Checkout has the capacity to improve returns for merchants on Google both due to higher click-through and due to lower processing costs. This is a direct threat to other search companies and we believe that Yahoo! and Microsoft (NASDAQ:MSFT) would be well served to integrate with PayPal to offer similar functionality to Google Checkout and that each should institute an incentive system.

We have Buy ratings on Google, Yahoo!, and eBay and recommending allocating near-term capital in that order. We continue to believe the revenue opportunities within large cap Internet companies more than offset higher capital spending and a more competitive environment.

We are experiencing a changing landscape in the internet industry driven by an innovative force that many, including ourselves, once underestimated, named Google. We believe Google has forced innovation in businesses that had begun to generate excess margins due to lack of competition. What is going on in the sector now is outstanding for all users of the Internet. What we find most interesting is that we believe the increased spending in the industry is actually leading to new revenue opportunities where none have existed in the past. We believe investors solely focused on the cost aspect of competition are missing the bigger picture which is the shift in all consumers discretionary time toward the Internet, the positive demographic trends around this shift, and the platforms that are being built on the Internet to serve consumers. We believe Internet platform companies will continue to act as a disintermediating force against legacy industries for several years. We would Buy Google (45% three-year CAGR, 31X forward FCF), Yahoo! (26% three-year CAGR, 31X forward FCF), and eBay (23% three-year CAGR, 20x forward FCF).

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Source: Is the Recently Launched Google Checkout a Loss Leader? (GOOG)