Background: Understanding PayPal's Source Mix
If you follow PayPal closely from a financial perspective, you realize that the key to model in PayPal is the 'source mix'. To take a step back, there are essentially three ways to fund a PayPal transaction from the consumer's perspective:
- Credit card - This usually costs PayPal as much or more than the rate they charge merchants. PayPal is highly motivated to REDUCE credit card usage. In fact if credit card was 95%+ of the source, Paypal's margin would be devastated.
- PayPal balance - You are essentially moving money between PayPal's servers so there is little to no cost here.
- Bank account - Usually called ACH, this is a bank to bank transfer of $ and in most scenarios is very inexpensive to process (.25-.50)
One analyst I follow, Scott Devitt @Stifel, has really started to get concerned this year about this fact. Here's a snippet from a recent report:
eBay continues to have profit pool risk, most notably within its PayPal business given the fact that it generates all of its profit from balance transfers and bank account transfers. As well, PayPal defaults users to its highest margin options, negatively impacting the consumer experience, and allowing for competitors to eventually innovate away PayPal's profit pool. Finally, even with success, PayPal's aggregation with the core commerce business will continue to limit its ability to be appropriately valued by the market.
His thesis is that the source mix is PayPal's strategic advantage, but also it's strategic weakness. What if there were a competing system that passed the true rates to merchants for these items? Such a system would have a sub 2% effective payment take rate. In theory it would be able to do this because the model would be built around something else. 3-4 yrs ago this seemed unlikely, but today you have Google (GOOG) Checkout, BillMeLater and there is some chatter that other large players are set to enter the field.
Devitt goes on to say:
PayPal makes all of its operating profit from PayPal balance funded transfers and bank account transfers. PayPal's credit card business is mostly a pass-through operation. Given this profit pool characteristic, PayPal defaults all user fund flows first through PayPal balance transfer and then through bank account transfer. If a consumer wants to pay with a credit card, it requires four extra steps and deteriorates the user experience. PayPal does this because it has to, as a mechanism for maintaining the company's profits. Amazon (AMZN) and Google do not have the same challenges, as payments are not a profit center for either company. In fact, we believe it is possible that Amazon could use ACH (bank
transfers) as a mechanism for lowering their own processing costs and consumer product costs (through processing cost saving share). We have not seen material changes in this area yet, given Google's slow start with Checkout and Amazon's still nascent payments offering but as they say in technology circles, "much less changes than one may expect in a year's time, much more over 5 years."
To my knowledge, eBay (EBAY) doesn't release the PayPal funding mix - but I did find it in their '06 analyst presentation and at that point it was 53% credit card, 17% balance and 30% bank.
The three metrics they do release: (these are Q108 numbers):
- Global PayPal take rate: 3.88%
- Transaction losses: .24%
- Transaction expenses: 1.18%
Thus PayPal essentially has a 3.88-.24-1.18=2.46% profit rate which gives it a 63% margin (much lower margin business than eBay core, but definitely better than Skype).
Bottom line: the entire key to the PayPal business model is the source mix.
PayPal uses consumer promo to drive mix?
A reader pointed out that when they login to their 'buyer' PayPal account, they are seeing this promotion: (BTW I love the image!)
As you can see, PayPal is now offering 1.5% money back to consumers who use the 'balance' or 'bank' source methods. There are a couple of interesting aspects of this program:
- It's fascinating that PayPal is passing some of the savings to buyers vs. sellers. Many payment systems drive consumer behavior via the merchant vs. direct to the consumer. The year of the buyer continues I guess.
- Note that this doesn't appear to be any kind of test. eBay tests usually have all kinds of time/amount/max/day of week/phase of the moon qualifiers that water them down and make the complex. This is simply 1.5% back, no limit, all of 2008.
- I haven't done the math yet, but this seems to be a better cash back rate than you would get from most credit card promos (miles/cash back/upromise/etc.)
Because of the vastly more profitable attributes of bank/balance funding source, if this promo moves the needle on those sources just a little, it will be a very accretive promotion. However, if for whatever reason it doesn't move the needle, it will effectively eat into the PayPal margin by 1.5% times some adoption rate (you have to sign up for the program).
Only PayPal insiders know the real driver behind this promotion, but here's the ones I see being on the table:
- Maybe they did a test of this and it was wildly profitable and they chose to expand it.
- I know the execs at eBay read Devitt's reports. Maybe they were persuaded by his 'profit pool risk' analysis and decided it was time to get a little defensive on this vs. waiting for a competitor to strike. Remember the adage the best offense is a strong defense?
- Maybe PayPal is seeing the mix swing in a negative direction and this is a move to try and swing it the other way?
eBay Strategies readers - what do you think about this promotion?
Disclosure: Author is long Google.