A Separate PayPal Still Must Solve the Payments Puzzle

Moving money through the pipes of the financial system is a grindingly mundane activity, but that has not stopped Wall Street and Silicon Valley from promoting it as a hot new thing.

The latest burst of excitement occurred on Tuesday, when eBay announced that it was going to spin off PayPal, its electronic payments unit, as a separate public company. Apple generated enormous hoopla in early September when it unveiled Apple Pay, a technology that may make it easier to pay for things with an iPhone.

Innovation needs a problem to solve. And in this case, the argument is that the traditional payments system - the vast, Byzantine plumbing that is made up of banks and credit card companies - is cumbersome and expensive. In the dreams of the disrupters, companies like MasterCard and Visa are vulnerable. So when PayPal trades as a stand-alone company next year, investors will have a way to bet on the revolution.

A closer look at PayPal's numbers, however, suggests that the old order is far from done.

PayPal has been hacking away at the established system since it was founded in 1998. To its credit, it has secured a substantial foothold that enabled it to process $180 billion in payments last year. Still, that progress has not generated the sort of high-octane profitability that technology investors yearn for, according to some analyses of the company.

Mark May, an analyst with Citigroup, says that, while PayPal has stronger growth than companies like Visa and MasterCard, it has weaker profit margins. He estimates that next year PayPal will earn $2.4 billion before interest, taxes, depreciation and amortization, known as Ebitda. That would represent an 18 percent increase from 2014. True, that growth rate is roughly double that attained by established payments companies, but PayPal's margins are much weaker.

PayPal makes 26 cents of Ebitda for every dollar of revenue, compared with roughly 65 cents for every dollar of revenue at Visa and MasterCard, Mr. May estimates. The cost of expanding its network has saddled PayPal with proportionately higher expenses. And a potential competitive threat from Apple Pay has also dimmed PayPal's prospects.

The upshot: Mr. May says that PayPal may end up having the same sort of valuation on the stock market as its established rivals. At 14 times his forecast for next year's Ebitda, PayPal would have a market value of $34 billion.

That is a mere fourth of Visa's value, yet much larger than the next wave of payments disrupters. Square, a payments company led by the Twitter co-founder Jack Dorsey, announced a financing last month that valued the private company at $6 billion. And Stripe, another online payments processor, also has attracted financing from prominent venture capitalists.

PayPal could break out big in payments in several ways.

Its business has one big advantage: It allows consumers to set up a PayPal account so that it deducts money directly from their bank accounts. Such transactions have far lower fees than typical credit card payments, making them more attractive for merchants, which pay the fees. Apple Pay, by contrast, works through the credit card companies, which means its transactions will often be more expensive than a bank debit through PayPal.

'Apple Pay is not cheaper,' Mr. May said. 'PayPal can be far cheaper for the merchant.'

The challenge for PayPal is finding ways to exploit these lower fees. One obvious idea would be to work with merchants to pass on some of the fee savings to customers, either in lower prices or rebates. Imagine a supermarket checkout offering two prices: One for paying with an established credit card, and a lower price for using PayPal. Such two-tier pricing has not yet appeared at many retailers, though some gas stations offer it. Still, over time, providing such an option to consumers might drive an increasing amount of transactions through lower-fee companies like PayPal, bolstering its revenue.

And as a stand-alone company, all of PayPal's resources could be aimed at tackling such challenges.

Still, the attraction of lower fees may not be enough. For instance, established credit card companies, using well-honed loyalty programs, have powerful ways of retaining consumers.

PayPal's success might, therefore, also depend on producing a technology that is markedly easier for consumers to use than a credit or debit card. Right now, paying for something with a phone is often no quicker than paying with a card. PayPal would need to improve on that, but its recent record in setting up easy payments in stores is not strong. And Apple Pay, with its iPhone fingerprint authorization, may catch on quickly, making it harder for PayPal to compete.

If Apple does steal such a lead, it will be on the back of the current payment system, and it could entrench the higher fees paid by merchants.

In other words, PayPal may be the only big disrupter in this battle. That is sure to get investors intrigued when its stock starts to trade. But it is precisely the thing that could make it a risky bet.

The move, which the activist hedge fund magnate Carl C. Icahn had called for, will cleave eBay almost in half and separate it from a company that generates almost half its revenue.