Why The $1 Billion Square Acquisition Might Have Been The Best Move For PayPal

| About: eBay Inc. (EBAY)

As most of you have heard, PayPal [owned by eBay (NASDAQ:EBAY)] will be launching a new service (and dongle) to compete directly with Square in the offline payment space, and believes it can swallow some of Square's market share. While I understand that a $1 billion valuation for Square may have seemed a bit much for PayPal execs to swallow, I believe such an acquisition would have been highly beneficial, and would ultimately have been cheaper than competing directly.

Acquired in 2002 for $1.5 billion, PayPal has had an immensely successful run, and is one of eBay's most profitable units. The company has recently released its vision for the future, to provide customers with "Integrated in-store, online and mobile shopping solutions that create a fully optimized end-to-end shopping experience", and intends to do so by competing in the offline payment space as well by taking on companies such as Square, which has to date processed over $4 billion worth of goods. PayPal has good reason to believe that it will succeed. With incredible brand recognition, over 106 million active accounts (13% increase year over year), excellent relationships with millions of merchants spread across various geographies, a wide suite of product capabilities, and an excellent risk management and claims system, PayPal believes it can leverage its current strengths and dominate the offline payment space as well. Compared with Square, PayPal is a behemoth. Backed by eBay's strong analytics team, and with total payment volume of $33.4 billion in the fourth quarter of 2011 and mobile payment volume of over $4.0 billion last year (a 500% increase from 2010), PayPal enjoys a significantly lower cost of capital than does Square. To top it all off, PayPal has announced that it will be charging five basis points less than Square's transaction fee of 2.75%, and is signaling that it intends to be aggressive about competing in the space.

However, Square is no small player, and unless merchants are willing to switch to PayPal immediately (something I would love to see a study on), it will continue to enjoy a dominant position in the market. Square is also willing to compete aggressively, and hired Alyssa Cutright, who until recently served as Vice President of Products for North America at PayPal. PayPal is not the first to compete with Square. Launched by accounting software firm Intuit Inc. (NASDAQ:INTU) in May 2009 and currently about half the size of Square, GoPayment is a software service that comes with a free card reading device, and has been steadily increasing market share. Other companies, such as Eventbrite, have also announced that they will be launching a service that would compete with Square in certain markets.

While we can expect fierce competition in this space in the future, I believe Square at a $1 billion valuation has never been cheaper. I am confident that PayPal will be successful in the offline payment space as well. However, I also believe that Square will be able to compete successfully with PayPal in the markets in which it is currently dominant. PayPal's move will undoubtedly make it difficult for Square to be a serious player in markets in which PayPal has a dominant online platform presence, but this should not have such a pronounced effect on Square's position in the U.S. market, and will not completely lock them out of foreign markets either. Assuming you accept this premise, Square will continue to grow in certain markets, and will continue to be a competitor of PayPal (assuming PayPal is successful in their endeavors as well). Given this scenario, it may very well have been cheaper to acquire Square, its market share, and its know-how at $1 billion, than to bear the costs of competing with it. Acquiring Square would allow PayPal to keep the 5 basis point fee reduction, which will prove to be significant over time, save on sales and marketing expenses associated with fierce competition (assuming PayPal is serious about dominating this space), and leverage Square's momentum of success across world markets.

Just as Square seems to have underestimated PayPal's willingness to compete in the offline payment space, I believe PayPal has underestimated Square's ability to remain competitive despite more aggressive competition. If Square continues to grow as it has (I expect we will see at least some slowing in growth), PayPal may end up acquiring it down the road at a higher valuation, or worse, Square could be acquired by an even larger player in the financial world, resulting in an even worse position for PayPal. PayPal will surely be successful, but I believe it could have done even better had it acquired Square.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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