"We believe PayPal (Nasdaq: PYPL) is a Rule Breaker. We're going to buy shares of the company for this portfolio sometime in the next five business days."

That was how today's column was slated to start. David Gardner recently wrote about PayPal in the Motley Fool Stock Advisor. Tom Jacobs just wrote about PayPal in Motley Fool Select. Readers of either publication would not have been surprised to hear today that we were going to buy the stock in this real-money portfolio.

Except... darn it, eBay (Nasdaq: EBAY) beat us to it, announcing that it'll buy the entire company. We believe that eBay got a very good deal. PayPal will immediately add to eBay's earnings and expand its business in a new but similar direction.

Opportunities taken -- by another
Initally, we were disappointed that PayPal is being acquired. PayPal was one of the most promising Rule Breakers we'd considered. It is already profitable; it leads an important, emerging, and ultimately immense industry -- that of online payment transactions; and, at $20, it had a reasonable valuation.

We felt we had a big winner here! We were just about to pounce when eBay swooped it up, buying the company for $1.5 billion -- an 18% premium to last Friday's price. Thanks a lot, eBay!

Now, on second thought, we're happy that eBay also saw the value in PayPal, and that eBay -- our portfolio's largest holding -- paid a reasonable price.

What price PayPal?
In a tax-free, stock-for-stock purchase, eBay is exchanging 0.39 shares of its stock for every share of PayPal. At yesterday's closing prices, that values PayPal at $21.93 per share, or about $1.36 billion in enterprise value. (eBay is also acquiring PayPal's $140 million in cash and no debt.)

PayPal was expected to earn $0.36 per share this year on a pro forma, after-tax basis, putting the stock's forward P/E at 61. Consensus estimates were $0.67 in earnings per share next year, up 86%. PayPal trades at 33 times that estimate. And, just like eBay, PayPal receives payment on transactions immediately, so it should generate excellent free cash flow.

So, eBay shareholders should be happy. Their company hasn't paid much of a premium, especially when you consider PayPal's large opportunities. Plus, eBay is paying for the company with its more expensive stock. While currently growing earnings under 60%, eBay trades at 75 times its 2002 earnings per share estimate, and 50 times year 2003 estimates. (It trades at 50 times its free cash flow run rate -- the last quarter times four -- while free cash flow soared in the first quarter, up 203%.)

The acquisition is expected to increase business momentum for both companies, in part because PayPal can be fully integrated on eBay. PayPal will continue to operate "independently," with its CEO, Peter Thiel, reporting to eBay's CEO, Meg Whitman.

PayPal figures
With 15 million registered users as of March 31, and adding 28,000 new accounts daily, PayPal expected $6.6 billion in transaction volume this year, resulting in $225 million in revenue.

eBay anticipated $1.1 billion in 2002 revenue prior to the PayPal acquisition, on about $13 billion in gross merchandise sales. The company ended last quarter with 46 million registered users. eBay and PayPal have many overlapping registered users and even overlapping transaction volume. About 60% of PayPal's business is conducted on eBay. However, the combined companies still look impressive, with $1.3 billion in initial annual revenue.

Q1 2002
               eBay         PayPal
Transactions   $3.1B        $1.3B
Revenue        $245M         $49M
Gross profit   $203M         $32M
Gross margin     83%          65%
Operating margin 30%         1.2%

Year 2002 Estimates
Transactions $13B $6.6B Revenue $1.1B $225M Earnings $0.76 $0.36

PayPal's current financials appear much as eBay's did when it went public in 1998. As part of our buy report, we were hypothesizing that PayPal could eventually have an even lighter business model (less expensive to run) than eBay. PayPal merely facilitates the trading of a number -- electronic money -- and skims the top for its fees, while eBay must host millions of auctions every day (at considerable expense) to collect a fee. eBay has tremendous 83% gross margins and aims for 35% operating margins. PayPal could eventually tie or better that.

eBay must think so, too, or it wouldn't buy PayPal. Remember how keen eBay was on pointing out that Half.com's margins would equal or better eBay's margins? eBay's management avoids large acquisitions that dilute profitability, and PayPal is its largest acquisition yet.

eBay earned an average 6.5% sales commission on each auction that it hosted in the first quarter. (I divided total merchandise sales by eBay's online auction revenue, excluding advertising and other revenue.) PayPal earned an average 3.1% sales commission on every transaction dollar it hosted last quarter. PayPal should earn about 3.5% in sales commissions in the second quarter.

But what's most important? Both eBay and PayPal enjoy capitalizing letters in odd places. That's what really led to this acquisition. What a great fit.

eBay's second quarter
It was strong. The company pre-announced GAAP net income of $0.19 per share, topping estimates by two cents, on revenue of approximately $266 million. Sales topped estimates -- with 48% domestic sales growth and 148% international sales growth.

So long, PayPal
Well, we'll own PayPal through eBay, and we're happy for it, but we'll never own it as an independent business as we planned. Oh, for opportunities missed. Oh, now we must keep searching for a new, strong Rule Breaker. Oh, too bad we're not in a poetic mood or we'd write one sad poem about this loss. Oh... well. Back to it.

Jeff Fischer's guitar gently weeps. He owns shares of eBay. The Fool has a disclosure policy.

Rule Breaker Portfolio Returns as of 7/08/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      +0.26%**   +0.86%   --      +0.13%
Month     -6.43%**   -1.28%   --      -3.94%
Year     -29.39%**  -14.90%   --     -27.93%
 8/4/94   20.78%     10.01%  11.63%    8.80%

*Dividends added.

**Please keep in mind that these figures will be distorted for the RB Port once a quarter when we deposit $12,500 in new cash. See next note! 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure accounts for the periodic deposits. Total return wouldn't be meaningful, because we started adding cash to the portfolio in July 2001. In a total return calculation, or (Current Value - All Cash Deposited)/All Cash Deposited, cash added shows up as returns.