Wall Street is having second thoughts about following PayPal from its online roots into the physical world.
PayPal, a leader online, launched a push in 2011 to become a payment option in brick-and-mortar stores. The move increases PayPal's potential market by a factor of at least 10, and has been a big driver of the shares of owner eBay, which surged 68% in 2012.
But ahead of an investor day meeting at eBay's Silicon Valley headquarters on Thursday, some investors and analysts are beginning to worry that the initiative will sacrifice profit margins for growth.
"Profitability of on-site payment will be dramatically lower than it is online," said Bill Smead of Smead Capital Management, an eBay shareholder who has been bullish on the company for several years. Smead's Seattle-based firm has trimmed its eBay position twice in the past year.
"If it's going to be a lot less profitable, PayPal may not expand there as much as previously thought," he added. "I would look for eBay to address this at the investor day."
An eBay spokesman declined to comment.
For the year, eBay's stock is up 0.6%, lagging behind the Nasdaq Composite Index's gain of 7.2% this year. Concern about lower profitability at PayPal has weighed on eBay's stock.
"Margin expansion may take a back seat to growth," Colin Sebastian, an analyst at RW Baird, wrote in a note previewing eBay's investor day.
Beware the digital wallet fee
This year, eBay has been trying to control Wall Street's expectations for PayPal profitability. On 16 January, the company said PayPal's 2013 margin would be 24%, down from a previous forecast of 25% to 26%.
In a 1 February regulatory filing, eBay mentioned a new fee that MasterCard plans to impose on "digital wallet" operators like PayPal, starting in June, and warned that such changes could increase PayPal's costs and reduce profit margins.
"Any time you take a successful business and move it to other arenas, there's great opportunity and risk," said Richard Sichel, chief investment officer of Philadelphia Trust Co. "There's lots of competition out there, and it's too early to know what PayPal margins will settle down to be."
If other payment networks follow MasterCard and impose a digital wallet fee on PayPal, that could shave 2 cents a share off eBay's earnings each year, Sanjay Sakhrani, an analyst at Keefe, Bruyette & Woods, estimated recently.
Even without pressure from MasterCard and Visa, PayPal's point-of-sale (POS) business will be less profitable than its online business, according to analysts.
PayPal has signed up several large retailers, including Home Depot, Toys 'R' Us and JC Penney, to accept PayPal in their stores. However, PayPal is taking a smaller cut of sales to persuade these retailers to test the service.
PayPal's POS business is only 30% as profitable as its online business, Brian Nowak, an analyst at Nomura, estimated in a note previewing eBay's investor day.
The bigger and potentially more expensive challenge will be to persuade consumers to drop their credit and debit cards in favour of PayPal when they shop in stores, Sebastian, Nowak and others say.
Nowak expects PayPal to develop a rewards programme to give users some incentives, similar to the ones offered by big credit card companies like Capital One Financial, American Express and Discover Financial Services.
However, if PayPal offered something like that, its profit margin on offline transactions would go negative, Nowak estimated.
On Thursday, during eBay's investor day, Nowak said he will be looking for the company to explain how PayPal can fund a rewards programme and still turn a profit processing in-store payments.
Merchants could share in the cost of a PayPal rewards programme, but this has its limits, Nowak said.
One of the reasons merchants are trying PayPal in the first place is that it is cheaper than what is currently offered by existing payment networks like Visa and MasterCard, the analyst noted.
PayPal has not disclosed what it is charging brick-and-mortar retailers, but Nowak estimates the company takes a cut of about 1.5%, compared with about 2% to 2.2% charged by Visa and MasterCard.
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