eBay Inc (EBAY): Does Paypal Has The Power To Compete In Digital Wallet Space?

Shares of eBay, Inc. (NASDAQ:EBAY) has underperformed the market by about 14 percent year-to-date, primarily due to competitive threats surrounding its PayPal unit from Apple, Inc. (AAPL) and Google, Inc. (NASDAQ:GOOG).

eBay's PayPal allows payments and money transfers to be made through the Internet that serve as electronic alternatives to paying with traditional paper methods, such as checks and money orders. As of the end of the second quarter 2013, PayPal had over 132 million user accounts globally.

Many investors have lost sight of the innovation taking place at PayPal. Over the past month, PayPal has released two significant product innovations - the enhanced mobile app and PayPal Beacon. These innovations act as a significant step forward in PayPal's push into offline payments and expand the company's total available market (TAM).

In September 2013, the company introduced an updated version of the PayPal mobile app for both iOS and Android. The much improved app features five clearly labeled sections on the home page, with the major sources of innovation residing within the new Shop tab and Bill Me Later integration.

"Despite some skepticism around digital wallets and offline payments, we believe that the new PayPal mobile app and the coming enhancements associated with PayPal Beacon provide a tangible rebuttal to this argument," UBS analyst Eric Sheridan said in a client note.

One of the key innovations of eBay includes PayPal Beacon. This product is a small hardware device that links merchant point of sale (POS) systems to customer PayPal apps via Bluetooth Low Energy (BLE). This product allows consumers to make hands-free purchases in retail stores and restaurants using their PayPal account.

The technology is being piloted in 2013, with a broader rollout scheduled for 2014. The initial geographies are expected to be the US, UK, Australia, Canada, Hong Kong, and Japan.

Importantly, the BLE technology enables transactions and geolocation services witho! ut the use of an internet connection or GPS, making wireless and/or cellphone networks unnecessary. Additionally, BLE allows for lower levels of battery consumption relative to GPS usage.

"We would note that further innovation could stem from this technology, as PayPal is incentivizing developers to submit enhancement and use-case ideas in exchange for a chance to be one of the first 100 developers given access to the API," Sheridan noted.

Over the coming years, developers are expected to incorporate this technology into new and existing mobile shopping apps. At eBay's March 2013 analyst day, the company noted that just 10 percent of PayPal's total payment volume (TPV) is currently being sourced via mobile. This would suggest significant runway, particularly in light of recently enhanced mobile app and the coming launch of PayPal Beacon in 2014.

PayPal's recent innovations (Beacon and the updated mobile app) could help to remove friction from the checkout process, enhance the consumer experience, and increase personalization efforts.

"This is the first innovation in the payments space that is definitively easier than swiping a credit card and that can be handled hands-free," Sheridan said.

Moreover, enhanced customer service offerings could attract new users onto the PayPal platform, particularly consumers who are regular customers at PayPal / Beacon enabled merchants.

Investors might be skeptical as Apple is also launching (with iOS 7) a competitive product. Apple's entry, the iBeacon, will provide similar capabilities to those of PayPal's Beacon. That said, the PayPal product will be available on both Android and iOS, versus the Apple product, which is limited to the iOS install base.

IDC estimates that approximately 79 percent of all global smartphones shipped in the second quarter 2013 were Android, versus just 13 percent iOS.

"The broader potential customer base for PayPal Beacon could make the offering more attractive merchants," Sheridan noted.

Further! , the market is currently underappreciating the potential reach associated with the long list of partnership agreements that eBay's PayPal unit has signed over the past few years.

PayPal has forged a long list of partnership agreements with consumer credit (Discover), money transfer (MoneyGram), and POS hardware and software providers (NCR, MICROS, etc.), helping to create the potential for more ubiquitous acceptance.

PayPal's expanding merchant coverage is expected to ramp over 7 million locations by 2015, from just 18,000 in 2012. Rather than take on the heavy lifting associated with going "door to door" to add merchants, PayPal is largely leveraging partners' existing merchants relationships.

"We believe that it is a matter of when, not if, the awareness and utilization of PayPal's acceptance begins to materialize in payment volumes," Sheridan wrote.

Another overlooked asset in Paypal's kitty is Bill Me Later. Bill Me Later was acquired by eBay in October 2008 for $945 million. The company provides a consumer credit service integrated into PayPal. This service allows consumers to make purchases online or through their mobile device without using a credit card.

The value proposition to consumers, aside from the credit extension, largely focuses on ease of use, a simplified application process, flexible payment options, and layers of security.

Importantly, eBay funds the Bill Me Later portfolio of loan receivables largely via offshore cash on the balance sheet. This allows eBay to monetize its offshore cash balance without suffering from cash repatriation taxes. For context, approximately 75 percent of eBay's close to $12 billion in cash and cash equivalents was held overseas as of the end of the second quarter.

"We see an opportunity for continued strong volumes for the consumer credit business given a) Bill Me Later's first incorporation into PayPal's updated mobile app; and the recently agreed to partnership with Alliance Data Systems," the analyst said.

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eBay e! xpects PayPal to post the strongest revenue growth of the company's three segments (22 percent 2012-2015 CAGR), while Marketplaces and eBay Enterprise (formerly GSI) are expected to contribute slower, yet still impressive revenue growth (14 percent 2012-2015 CAGR).

"Our 2015 PayPal revenue forecast is approximately 5% above the midpoint of the guided range, which we believe is warranted given recent innovation and user growth trends experienced within the unit," Sheridan added.

As such, the above opportunities are underappreciated by the market, and positions PayPal to compete effectively against potential competition from Apple, Square, and Google.