eBay (NASDAQ:EBAY) unveiled a nice little surprise for investors with its fourth-quarter earnings report. Well, nice for eBay; not so nice for PayPal Holdings (NASDAQ:PYPL). The online marketplace will start taking control of payments on its platform instead of using PayPal to process payments.
This is a significant move for both companies, as the two have had a long relationship, and eBay presents a significant portion of payment volume and revenue for PayPal. The payments service was a subsidiary of eBay until 2015, when it was spun off.
There are several important things for investors to understand about the future relationship between eBay and PayPal.
1. Not much will happen until 2020
It's not as if shoppers visiting eBay today are suddenly unable to use PayPal to check out. The current operating agreement with PayPal requires nearly all of eBay to send nearly all of its payment processing to PayPal.
For the next year and a half, eBay will be able to process 5% of payments in two countries of its choice. That jumps up to 10% in mid-2019, and it lasts until the end of the operating agreement in July 2020. At that point, eBay will be able to handle all of its payments itself.
That said, eBay expects to incur significant costs as it prepares to process transactions in house instead of using PayPal. And since it's limited in how much it can process, those investments will negatively affect earnings per share by $0.03 to $0.05 in 2018, according to CFO Scott Schenkel.
2. PayPal will still be a payment option long after it stops processing payments
eBay is only switching payment processors in 2020. Currently, when a user types credit card information directly into eBay, PayPal is still working in the background to move the money from the user's account to the seller's. That's the only piece that's changing next decade.
In fact, the two companies struck a new agreement to keep PayPal as a payment option on the platform for another three years following the end of the operating agreement -- extending the relationship to July 2023. So there's no need to worry that the option to pay with PayPal on eBay is going away anytime soon.
3. This has been the plan all along
eBay and PayPal entered this operating agreement as part of the spinoff process in 2015. The agreement lasts for five years. The point of the agreement was to provide for a smooth transition as PayPal became an independent company once again.
PayPal's management has always known it was highly unlikely it would continue processing payments for eBay after the operating agreement ended. To that end, all of its guidance, including its 2018 full-year and mid-term guidance, includes the assumption that it wouldn't receive that business.
PayPal has been preparing investors for this event without their even knowing it. Someone who really dug into the weeds of the agreement might have seen it coming, but it was clearly a surprise to most investors based on the changes in the stock prices for eBay and PayPal following the announcement.
4. It's a $2 billion opportunity for eBay
When eBay completes its transition from PayPal to take care of transactions itself, with the help of Dutch company Adyen, it expects to generate more than $2 billion in incremental revenue. By cutting out the middleman, eBay thinks it can lower the total fees its sellers pay while keeping more money for itself.
Realizing that revenue opportunity will require some investments on eBay's part as well as continued operating expenses. As such, management says investors should expect about $500 million in additional operating income once payments volume reaches a steady state early next decade.
It's also worth noting that eBay expects to complete the transition quickly following the end of its operating agreement, but it wouldn't give a definitive timeline.
5. PayPal thinks the impact is "manageable"
As mentioned, PayPal has been baking in the end of the partnership with eBay in its guidance since it spun off.
What's more, eBay is a shrinking percentage of PayPal's total payments volume. Last quarter, eBay accounted for 13% of volume. That's down from 16% last year and 19% the year before. Management pointed out that if it keeps up the same cadence, eBay could account for just 4% of payment volume and less than 10% of revenue on its platform by the time the operating agreement ends.
In addition, PayPal expects to retain a large percentage of its branded business on eBay -- where people still opt to pay with PayPal instead of entering their credit card information at checkout. Management says that's a much more profitable business than back-end payments processing. PayPal's past experience with situations like this had the company retain 50% of transactions.
6. New opportunities for PayPal
While eBay has been forced to continue using PayPal as its payments processor for five years, PayPal's end of the bargain was that it can't act as merchant of record for eBay's direct competitors during that period.
With the end of the operating agreement, it opens the door for PayPal to start processing payments for some of the largest merchants in the world, some of which management says have already expressed interest in working with PayPal.
7. The market went crazy
eBay stock was up nearly 14% and PayPal was down over 8% the day following the news. Both appear to be overreactions to the realities of the situation.
eBay still has a lot of work to do to make that $2 billion revenue opportunity a reality.
While the end of the operating agreement presents a challenge for PayPal, the company has shown incredible strength growing its business outside of eBay and is still on track to meet its mid-term guidance of 15% revenue growth and total payment volume growth in the mid-20% range.
As such, it may be an opportunity for investors to buy some PayPal, but I'd be wary about buying eBay at this price.