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| EBAY > SEC Filings for EBAY > Form 10-K on 8-Mar-2004 | All Recent SEC Filings |
8-Mar-2004
Annual Report
FORWARD LOOKING STATEMENTS
This report contains statements that involve expectations, plans or intentions (such as those relating to future business or financial results, new features or services, or management strategies). These statements are forward-looking and are subject to risks and uncertainties, so actual results may vary materially. You can identify these forward-looking statements by words such as "may," "will," "should," "expect," "anticipate," "believe," "estimate," "intend," "plan" and other similar expressions. You should consider our forward-looking statements in light of the risks discussed under the heading "Risk Factors That May Affect Results of Operations and Financial Condition below, as well as our consolidated financial statements, related notes, and the other financial information appearing elsewhere in this report and our other filings with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements.
You should read the following Management's Discussion and Analysis of Financial Condition and Results of Operations in conjunction with the Consolidated Financial Statements and the related notes that appear elsewhere in this document.
Overview
About eBay
We pioneered online trading by developing an Internet-based marketplace in which a community of buyers and sellers are brought together in an entertaining, intuitive, easy-to-use environment to browse, buy and sell an enormous variety of items. Through our PayPal service, we enable any business or consumer with email to send and receive online payments securely, conveniently and cost-effectively.
Executive Operating and Financial Summary
Members of our senior management team regularly review key operating metrics such as new users, active users, listings and gross merchandise sales transacted on our global marketplace as well as new user accounts, total payment volume and off-eBay transactions processed by our wholly-owned PayPal subsidiary. This information allows us to monitor marketplace trends and anticipate new features and functionality that may be required to serve the needs of our users. We believe that an understanding of the key operating metrics and how they change over time is important to investors, analysts and other parties analyzing our market opportunities and business results.
Members of our senior management also regularly review key financial information including net revenues, operating income margins, earnings per share, cash flows from operations and free cash flows, which we define as operating cash flows less purchases of property and equipment. This information allows us to monitor the profitability of our business and evaluate the effectiveness of investments that we have made and continue to make in the areas of international expansion, customer support, product development, marketing and site operations. We believe that an understanding of key financial information and how it changes over time is important to investors, analysts and other parties analyzing our business results and future market opportunities.
We expect that our growth in net revenues during 2004 will result primarily from transaction net revenues across our U.S., International, and Payments segments, with a potentially more significant effect of seasonality during the second and third quarters. The expected future growth in our Payments segment net revenues will also cause downward pressure on our gross margin and operating profit margin. We continue to make investments in our business and infrastructure to help us achieve our long-term growth objectives. We expect to continue our investments in the areas of international expansion, product development, site operations and various corporate infrastructure areas. We believe these investments are necessary to support the long-term demands of our growing business. In addition, to the extent that the
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U.S. dollar strengthens or weakens against foreign currencies, and, in particular, the Euro, the translation of these foreign currency denominated transactions into U.S. dollars will impact our net revenues, operating expenses and net income.
The detailed discussion of our financial condition and results of operations contained herein is intended to provide information to assist investors, analysts and other parties reading this report understand the key operating metrics and financial information summarized above as well as the changes in our results of operations from year to year, the primary factors that accounted for those changes and how certain accounting principles, policies, judgments, and estimates affect our Consolidated Financial Statements.
Business Combinations
Our historical financial statements reflect the impact of various business combinations that have been accounted for as pooling-of-interests and purchase transactions. Our Consolidated Financial Statements have been retroactively restated to include the historical financial statements of all entities acquired in pooling-of-interests transactions. The financial statements of entities acquired in purchase transactions are reflected in our consolidated results from the effective dates of each acquisition. The aggregate purchase price for all acquisitions using the purchase method of accounting during the three years ended December 31, 2003 totaled approximately $2.1 billion and was been allocated in our Consolidated Financial Statements as follows (in thousands):
Net tangible assets $ 207,717
Identifiable intangible assets 326,353
Deferred tax liabilities (51,000 )
Minority interests (21,690 )
Unearned compensation 9,943
Goodwill 1,665,257
---------
$ 2,136,580
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Tangible net assets were valued at their respective carrying amounts as we believe that these amounts approximated their current fair values at the respective acquisition dates. The valuation of identifiable intangible assets acquired was based on management's estimates using valuation reports prepared by an independent third-party valuation consultant. Such assets consist of customer lists, trademarks and tradenames, developed technologies and other acquired intangible assets including contractual agreements. Identifiable intangible assets are amortized using the straight-line method over the estimated useful lives of one to seven years. We believe the straight-line method of amortization best represents the distribution of the economic value of the identifiable intangible assets. Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in each business combination. In accordance with SFAS No. 142, goodwill is no longer subject to amortization. Rather, goodwill is subject to at least an annual assessment for impairment, applying a fair-value based test. See "Note 1 The Company and Summary of Significant Accounting Policies" and "Note 3 Business Combinations, Goodwill and Intangible Assets" to our Consolidated Financial Statements, which we incorporate by reference herein.
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Results of Operations
The following table sets forth, for the periods presented, certain data from our consolidated statement of income as a percentage of net revenues. This information should be read in conjunction with "Critical Accounting Policies, Judgments and Estimates" as well as our Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report on Form 10-K.
Year Ended December 31,
-----------------------------------------
2001 2002 2003
----------- ----------- -----------
Net revenues 100.0 % 100.0 % 100.0 %
Cost of net revenues 18.0 17.6 19.2
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Gross profit 82.0 82.4 80.8
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Operating expenses:
Sales and marketing 33.8 28.8 26.2
Product development 10.1 8.6 7.4
General and administrative 14.1 14.1 14.0
Patent litigation expense 1.4
Payroll tax on employee stock options 0.3 0.3 0.4
Amortization of acquired intangible assets 4.9 1.3 2.3
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Total operating expenses 63.2 53.1 51.7
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Income from operations 18.8 29.3 29.1
Interest and other income, net 5.6 4.1 1.7
Interest expense (0.4 ) (0.1 ) (0.2 )
Impairment of certain equity investments (2.2 ) (0.3 ) (0.1 )
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Income before cumulative effect of accounting change, income
taxes and minority interests 21.8 32.8 30.6
Provision for income taxes (10.7 ) (12.0 ) (9.5 )
Minority interests 1.0 (0.2 ) (0.4 )
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Income before cumulative effect of accounting change 12.1 20.6 20.7
Cumulative effect of accounting change, net of tax (0.3 )
----- ----- -----
Net income 12.1 % 20.6 % 20.4 %
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Net Revenues Summary
Percent Percent
2001 Change 2002 Change 2003
------------- --------- ----------------- --------- -----------------
(in thousands, except percent changes)
Segment Net Revenues:
U.S. $ 617,011 32 % $ 816,596 30 % $ 1,062,834
International 114,162 165 % 302,136 120 % 664,640
Payments 17,648 440 % 95,368 359 % 437,622
------- --- --------- --- ---------
Total net revenues $ 748,821 62 % $ 1,214,100 78 % $ 2,165,096
------- --- --------- --- ---------
Transaction net revenues:
U.S. $ 474,970 51 % $ 718,239 43 % $ 1,024,915
International 110,802 168 % 297,485 121 % 657,874
Payments 16,899 452 % 93,303 360 % 429,453
------- --- --------- --- ---------
Total transaction net revenues 602,671 84 % 1,109,027 90 % 2,112,242
Advertising and other non-transaction
net revenues 146,150 (28 )% 105,073 (50 )% 52,854
------- --- --------- --- ---------
Total net revenues $ 748,821 62 % $ 1,214,100 78 % $ 2,165,096
------- --- --------- --- ---------
Geographical Net Revenues:
U.S. $ 634,659 41 % $ 897,701 57 % $ 1,406,512
International 114,162 177 % 316,399 140 % 758,584
------- --- --------- --- ---------
Total net revenues $ 748,821 62 % $ 1,214,100 78 % $ 2,165,096
------- --- --------- --- ---------
Net revenues are allocated between U.S. and International geographies based upon the country in which the seller, payment recipient, advertiser or service provider is located.
The U.S. segment includes our U.S. online trading platforms, excluding those of our PayPal and Billpoint subsidiaries. The International segment includes our international online trading platforms excluding those of our PayPal and Billpoint subsidiaries. The Payments segment includes our global payments platform including the operations of our PayPal and Billpoint subsidiaries. The Payments segment reflects Billpoint's historical operations and PayPal's operations for the periods subsequent to October 3, 2002. We completed our planned wind-down of Billpoint in the first half of 2003.
Our net revenues result from fees associated with our transaction, advertising and other services in our U.S., International and Payments segments. Transaction net revenues are derived primarily from listing, feature and final value fees paid by sellers and fees from payment processing services. Net revenues from advertising are derived principally from the sale of online banner and sponsorship advertisements for cash and through barter arrangements. Other net revenues are derived principally from contractual arrangements with third parties that provide transaction services to eBay and PayPal users and also from offline services provided by our Butterfields and Kruse subsidiaries, which were divested in the second half of 2002.
The successive year-over-year growth in net revenues from 2001 through 2003, was primarily the result of increased auction and fixed-price transaction activity, reflected in the growth in the number of our confirmed registered users, user activity, listings, gross merchandise sales and payment transactions processed by PayPal. Our net revenue growth during the year ended December 31, 2003, also reflects a full year of payment transactions processed by PayPal, which we acquired on October 3, 2002.
The number of confirmed registered users from our U.S. and International segments increased 54% during 2003 to 94.9 million at December 31, 2003. Confirmed registered users increased 45% during 2002 to 61.7 million at December 31, 2002, from 42.4 million at December 31, 2001. The increase in registered users reflects steady growth across our U.S. and international platforms.
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The number of active users on the eBay platform (which excludes the Internet Auction and EachNet websites) increased 49% during 2003 to 41.2 million at December 31, 2003. Active users increased 56% during 2002 to 27.7 million at December 31, 2002, from 17.8 million at December 31, 2001. Active users are the number of users on the eBay platform who bid, bought or listed over the trailing twelve months. We believe that increases in user activity are largely the result of our promotional efforts and our emphasis on helping our user community be successful through the introduction of new site features and functionality and expanded trust and safety programs.
The number of items listed on eBay.com and our international sites increased by 52% to 971.0 million in 2003, from 638.3 million in 2002, and increased 51% in 2002 from 423.1 million in 2001. This acceleration in listing growth was experienced across our U.S. and international platforms.
Gross merchandise sales from the U.S. and International segments increased 60% in both 2003 and 2002. Significant contributions to this growth came from our U.S., German, U.K. and South Korean operations. eBay transaction net revenues as a percentage of gross merchandise sales was 7.1% in 2003, 6.8% in 2002 and 6.3% in 2001.
During 2003, over $12.2 billion in TPV was transacted on the PayPal platform. As of December 31, 2003, PayPal had 40 million accounts, compared to 23 million accounts at December 31, 2002.
U.S. and International Segment Net Transaction Revenues
U.S. segment transaction net revenues increased 43% in 2003 and 51% in 2002. International segment transaction net revenues increased 121% in 2003 and 168% in 2002. The successive year-over-year growth in U.S. and International segment transaction net revenues was primarily the result of increased auction transaction activity, reflected in the growth of the number of registered users, listings and gross merchandise sales. We experienced transaction net revenue growth across all major categories with motors, home & garden, computers, consumer electronics, clothing & accessories, and collectibles making the most significant dollar impact.
International segment transaction net revenues as a percentage of total transaction net revenues was 31% in 2003, 27% in 2002 and 18% in 2001. This growth is primarily the result of strong performances in Germany, the United Kingdom and South Korea. Additionally, the relative strength of foreign currencies, primarily the Euro, against the U.S. dollar resulted in increased net revenues of approximately $82.0 million during 2003, when compared to the weighted-average foreign currency exchange rates used in the preparation of our 2002 Consolidated Financial Statements. Our operations located in Europe experienced seasonally slower growth in July and August, with September and the fourth quarter of 2003 showing improved activity in all markets. We expect that International segment transaction net revenues will continue to grow in significance to our business as we continue to develop and deploy our global online trading platform during 2004.
On July 1, 2003, eBay began collecting value-added taxes, or VAT, on the fees we charge certain sellers in the European Union, or EU. We continue to work with the relevant tax authorities to clarify our obligations under these new regulations. There have been and will continue to be substantial ongoing costs associated with complying with the VAT rules throughout the EU, and the increased costs to our European users may reduce their activity on our websites and could adversely affect our international transaction net revenues. We also believe that changes in foreign currency rates will impact our operations and to the extent that the U.S. dollar strengthens, our foreign currency denominated transaction net revenues will be negatively impacted.
Payments Segment Net Transaction Revenues
Payments segment transaction net revenues increased 360% in 2003 and 452% in 2002. The year-over-year growth in 2003 reflects a full year of transaction activity from PayPal and substantial increases in transaction volume. The Payments segment contributed approximately 20% of our total net transaction revenues in 2003 compared to 8% in 2002.
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PayPal payment volume totaled $12.2 billion in 2003, and transaction net revenues as a percentage of total payment volume was 3.5%. The growth in Payments transaction net revenues was also positively affected by PayPal's continued penetration of eBay transactions in the United States and the United Kingdom, growth in our cross border international payment transactions and growth in the off-eBay business. Net transaction revenues from the Payments segment earned internationally totaled $93.9 million during 2003, representing 21.9% of total Payments segment net transaction revenues. We expect the Payments segment transaction net revenues to increase in absolute dollars and as a percentage of total transaction net revenues during 2004.
Advertising and Other Net Revenues
Advertising and other net revenues decreased in both absolute dollars and as a percentage of total net revenues. Advertising and other net revenues totaled $52.9 million in 2003, $105.1 million in 2002 and $146.2 million in 2001. These amounts as a percentage of total net revenues represented 2% in 2003, 9% in 2002 and 20% in 2001. The decrease in net revenues from advertising and other services was primarily the result of a general deterioration in the online advertising market in 2002, our decision in 2002 to no longer use America Online as our sales agent in the online advertising market, and our divestiture of both of our offline businesses in 2002. We continue to view our business as primarily transaction driven and we expect advertising and other net revenues to continue to decrease as a percentage of total net revenues and possibly in absolute dollars during 2004.
Cost of Net Revenues
Percent Percent
2001 Change 2002 Change 2003
----------- --------- ----------- --------- -----------
(in thousands, except percent changes) Cost of net revenues $ 134,816 59 % $ 213,876 95 % $ 416,058 As a percentage of net revenues 18 % 18 % 19 %
Cost of net revenues consists primarily of costs associated with customer support, site operations and payment processing. Significant cost components include bank charges, credit card interchange, other payment processing costs, employee compensation and facilities costs for our customer support and site operations, Internet connectivity charges, depreciation of equipment, amortization of required capitalization of major site and product development costs, and certain corporate overhead allocations.
Cost of net revenues increased in absolute dollars and slightly as a percentage of net revenues during 2003 as compared to 2002. The increase in absolute dollars was due to a full year of payment processing costs resulting from our acquisition of PayPal on October 3, 2002, an increase in the volume of transactions on the eBay websites, and continued development and expansion of our customer support and site operations infrastructure. The increase in cost of net revenues as a percentage of net revenues was primarily due to the impact of PayPal's higher structural costs relating to payment processing offset, in part, by eBay's site operations costs growing at a slower rate than net revenues. Payment processing costs increased to $215.7 million in 2003 from $120.8 million in 2002, reflecting the full year of PayPal activity in 2003, the substantial increase in PayPal's total payment volume and increased payment processing costs related to the collection of our eBay fees. Aggregate customer support and site operations costs increased $80.0 million during 2003, compared to the prior year, and resulted primarily from an increase in headcount and related employee costs of approximately $26.5 million. In addition, aggregate depreciation of site equipment and amortization of capitalized software development costs increased $21.5 million as compared to 2002. Costs of net revenues are expected to increase in absolute dollars and to remain generally comparable as a percentage of net revenues during 2004.
Cost of net revenues increased in absolute dollars but remained generally constant as a percentage of net revenues in 2002. The increase in absolute dollars was due to payment processing costs primarily resulting from our acquisition of PayPal on October 3, 2002, an increase in the volume of transactions on the eBay websites, and continued development and expansion of our customer support and site operations
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infrastructure. The consistency of costs of net revenues as a percentage of net revenues was primarily due to the offsetting impacts of PayPal's higher structural costs relating to payment processing and eBay's cost savings as site operations costs grew at a slower rate than net revenues. Payment processing costs, which consist of credit card interchange fees, bank charges, and other processing charges increased by approximately $50.4 million in 2002. The increase in aggregate customer support and site operations costs totaled $18.6 million in 2002.
Operating Expenses
Sales and Marketing
Percent Percent
2001 Change 2002 Change 2003
----------- --------- ----------- --------- -----------
(in thousands, except percent changes) Sales and marketing $ 253,474 38 % $ 349,650 62 % $ 567,565 As a percentage of net revenues 34 % 29 % 26 %
Sales and marketing expenses consist primarily of advertising, tradeshow and other promotional costs, employee compensation for our category development and marketing staff, certain trust and safety programs and certain corporate overhead allocations.
Sales and marketing expenses increased in absolute dollars in 2003, but decreased as a percentage of total net revenues due to the continued cost leverage in our business and the acquisition of PayPal, which presently has a significantly lower sales and marketing requirement. Growth in advertising and marketing costs as well as employee-related costs comprised the majority of the increases in absolute dollars. Combined advertising and marketing costs increased $155.2 million in 2003. This increase was primarily the result of our marketing programs directed towards our Internet marketing and national television advertising campaigns as well as several category-focused print campaigns. Employee-related costs increased by $34.0 million in 2003 as we continued to expand our international operations. Sales and marketing expenses are expected to increase in absolute dollars, and to remain generally comparable as a percentage of net revenues during 2004. In addition, our 2004 online marketing expenses will likely increase because of increases in the volume of, and rates for, online advertising that we expect to purchase in order to attract new customers and increase the activity on our websites.
The increase in sales and marketing expense in 2002, was primarily the result of year-over-year increases in advertising costs of $54.7 million, referral fees paid to marketing partners of $12.6 million and other aggregate expenses related to trade shows and professional fees of $10.5 million.
Product Development
Percent Percent
2001 Change 2002 Change 2003
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(in thousands, except percent changes) Product development $ 75,288 39 % $ 104,636 52 % $ 159,315 As a percentage of net revenues 10 % 9 % 7 %
Product development expenses consist primarily of employee compensation, payments to outside contractors, depreciation on equipment used for development and certain corporate overhead allocations. Product development expenses are net of required capitalization of major site and other product development efforts, including the development of our "V3" platform architecture, global billing, seller tools and payment gateway projects. These capitalized costs totaled $38.5 million in 2003, $15.5 million in 2002 and $6.7 million in 2001, and are reflected as a cost of net revenues when amortized in future periods. We anticipate that we will continue to devote significant resources to product development in the future as we add new features and functionality to the eBay and PayPal platforms.
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The increase in absolute dollars in 2003, was primarily the result of increased headcount and computer equipment depreciation. These increases were partially offset by the amounts capitalized in connection with major site and other product development efforts in 2003. The headcount growth was focused on hiring new employees for various platform development initiatives at eBay and PayPal. Our development staff increased 60% from 635 at December 31, 2002 to 1,007 at December 31, 2003. Product development expenses are expected to increase in absolute dollars and slightly as a percentage of net revenues in 2004, as we develop new site features and functionality and continue to improve and expand operations across all our segments.
The increase in absolute dollars in 2002, was primarily the result of an $18.9 million increase in employee compensation costs, resulting from the growth in our development staff, which increased to 635 at December 31, 2002 from 320 at December 31, 2001, and a $7.3 million increase in maintenance and depreciation costs for equipment used in product development.
General and Administrative
Percent Percent
2001 Change 2002 Change 2003
----------- --------- ----------- --------- -----------
(in thousands, except percent changes) General and administrative $ 105,784 62 % $ 171,785 76 % $ 302,703 As a percentage of net revenue 14 % 14 % 14 %
General and administrative expenses consist primarily of employee compensation, provision for doubtful accounts, provisions for transaction losses associated with our Payments segment, insurance, fees for external professional advisors and certain corporate overhead allocations.
The increase in absolute dollars in 2003, was due primarily to employee and facilities related costs, fees for external professional advisors, payment transaction loss expenses resulting from our acquisition of PayPal and charges associated with various legal matters. The increases in employee and facilities related costs resulted from the addition of PayPal employees in various trust and safety functions as well as continued headcount growth in the finance, human resource and legal departments to meet the demands of our expanding business, including growing international operations and the integration of acquired businesses. We increased our general and administrative staff from 1,253 at December 31, 2002 to 1,944 at December 31, 2003. Fees for external professional advisors increased by $10.4 million. Charges associated with various legal matters recorded in general and administrative expense totaled $8.6 million. PayPal's payment transaction loss increased $28.6 million in 2003, reflecting a full year of consolidated operations. PayPal's payment transaction loss rate, which is the transaction loss expense as a percentage of PayPal's total payment volume, was 0.30% in 2003. Despite higher transaction loss rates expected to be experienced as a result of increased patterns of seasonality and the buyer protection program implemented in September 2003, we expect our full year transaction loss rate will decrease during 2004. With our continued investment in the infrastructure needed to support our business, primarily in our International and Payments segments as well as in our corporate functions, we expect general and administrative expenses to increase in absolute dollars and to remain generally comparable as a percentage of net revenues during 2004.
The increase in absolute dollars in 2002, was primarily the result of increases of $16.0 million in fees for external professional advisors, $7.8 million in the provision for transaction losses, and $6.5 million in facilities costs. These costs increased to meet the demands of our expanding business, including operations in new countries and the integration of new businesses. To support this growth, we increased our general and administrative staff from 415 at December 31, 2001 to 1,253 at December 31, 2002, which includes the addition of approximately 360 general and administrative employees resulting from our acquisition of PayPal. Of these incremental PayPal employees, a substantial number support PayPal's various trust and safety programs.
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Patent Litigation Expense
Percent Percent
2001 Change 2002 Change 2003
-------- ---------- ------ ---------- ----------
(in thousands, except percent changes)
Patent litigation expense N/A N/A $ 29,965
As a percentage of net revenues 1 %
Patent litigation expense during 2003 relates to the accrual of an August 6, 2003 court judgment resulting from the MercExchange patent infringement lawsuit. See "Note 11 Commitments and Contingencies" to our Consolidated Financial Statements.
Payroll Tax on Employee Stock Options
Percent Percent
2001 Change 2002 Change 2003
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(in thousands, except percent changes) Payroll tax on employee stock options $ 2,442 64 % $ 4,015 139 % $ 9,590 As a percentage of net revenues 0 % 0 % 0 %
We are subject to employer payroll taxes on employee gains resulting from exercises of non-qualified stock options. These employer payroll taxes are recorded as a charge to operations in the period in which such options are exercised and sold based on actual gains realized by employees. The increases in 2003 and 2002 were primarily a result of larger individual gains recognized on stock option exercises by our employees during periods in which our stock price was high relative to historic levels. Our results of operations and cash flows could vary significantly depending on the actual period that stock options are exercised by employees and, consequently, the amount of employer payroll taxes assessed. In general, we expect payroll taxes on employee stock option gains to increase during periods in which our stock price is high relative to historic levels.
Amortization of Acquired Intangible Assets
Percent Percent
2001 Change 2002 Change 2003
------------ ---------- ------------ ------------ ------------
(in thousands, except percent changes) Amortization of acquired intangible assets $ 36,591 (56 )% $ 15,941 218 % $ 50,659 As a percentage of net revenues 5 % 1 % 2 %
From time to time we have purchased, and we expect to continue purchasing, assets or businesses to accelerate category and geographic expansion, increase the features and functions available to our users and maintain a leading role in online trading. These purchase transactions may result in the creation of acquired intangible assets and lead to a corresponding increase in the amortization expense in future periods.
Intangible assets include purchased customer lists, trademarks and tradenames, developed technologies, and other intangible assets. We amortize intangible assets, excluding goodwill, using the straight-line method over estimated useful lives ranging from one to eight years. We believe the straight-line method of amortization best represents the distribution of economic value of the identified intangible assets.
Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. In accordance with SFAS No. 142, goodwill is subject to assessment for impairment and is no longer subject to amortization. Rather, goodwill is subject to at least an annual assessment for impairment, applying a fair-value based test. We evaluate goodwill, at a minimum, on an annual basis and whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit's carrying amount, including goodwill, to the fair value of the
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reporting unit. The fair values of the reporting units are estimated using a combination of the income, or discounted cash flows, approach and the market approach, which utilizes comparable companies' data. If the carrying amount of the reporting unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any. Our annual impairment test was carried out as of August 31, 2003 and there were no events or circumstances from that date through December 31, 2003 that would impact this assessment.
The increased amortization expense in 2003 primarily reflects the full-year amortization resulting from our acquisition of PayPal on October 3, 2002. Amortization of acquired intangible assets decreased during 2002, primarily from the elimination of goodwill amortization as part of our adoption of SFAS No. 142, "Goodwill and Other Intangible Assets" on January 1, 2002. We expect amortization of acquired intangible assets will increase in 2004 as a result of the incremental acquired intangible assets associated with our purchase of additional ownership interests in EachNet and Internet Auction Co. during 2003.
Non-Operating Items
Interest and Other Income, Net
Percent Percent
2001 Change 2002 Change 2003
---------- --------- ---------- --------- ----------
(in thousands, except percent changes) Interest and other income, net $ 41,613 18 % $ 49,209 (23 )% $ 37,803 As a percentage of net revenues 6 % 4 % 2 %
Interest and other income, net consists of interest earned on cash, cash equivalents and investments as well as foreign exchange transaction gains and losses and other miscellaneous non-operating transactions.
Our interest and other income, net decreased in absolute dollars and as a percentage of net revenues during 2003, primarily as a result of one-time gains recognized in 2002 from the sale of certain subsidiaries, real estate properties and an equity investment that totaled $20.3 million. This decrease was offset, in part, by increased investment income on a larger aggregate balance of cash, cash equivalents and investments even though the weighted-average interest rate of our portfolio declined to 1.6% in 2003 from 2.8% in 2002. We expect that interest and other income, net, will increase in absolute dollars during 2004, as our cash, cash equivalents, and investments balances continue to grow.
Our interest and other income, net increased during 2002 primarily as a result of one-time gains from the sale of certain subsidiaries, real estate properties and an equity investment that totaled $20.3 million. These gains were offset by a decrease in interest and investment income of $4.1 million resulting from lower average interest rates, despite an increase in our cash, cash equivalents and investments balances in 2002 and from decreased realized gains on the sale of investments, and a decrease in foreign exchange gains of $3.5 million. Our weighted-average interest rate decreased to approximately 2.8% in 2002 from 3.6% in 2001.
Interest Expense
Percent Percent
2001 Change 2002 Change 2003
--------- --------- --------- ---------- ---------
(in thousands, except percent changes)
Interest expense $ 2,851 (48 )% $ 1,492 189 % $ 4,314
As a percentage of net revenues 0 % 0 % 0 %
Interest expense consists of interest charges on mortgage notes, capital leases and our consolidated operating lease arrangement related to our San Jose corporate headquarters.
In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest Entities." In accordance with the provisions of this standard, we have included our San Jose headquarters lease arrangement in our Consolidated Financial Statements effective July 1, 2003. Beginning July 1, 2003, our
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income statement reflects the reclassification of lease payments on our San Jose headquarters from operating expense to interest expense. The increase in interest expense in 2003, is primarily the result of this new accounting standard. We expect our interest expense will increase in absolute dollars, due to the inclusion of a full year of the interest payments on our San Jose lease, and will remain generally comparable as a percentage of net revenue during 2004.
The decrease in interest expense during 2002, compared to the prior year, was primarily the result of a reduction in the outstanding mortgage note balances in connection with the sale of certain underlying properties.
Impairment of Certain Equity Investments
Percent Percent
2001 Change 2002 Change 2003
------------ ---------- ---------- ---------- ----------
(in thousands, except percent changes) Impairment of certain equity investments $ 16,245 (77 )% $ 3,781 (67 )% $ 1,230 As a percentage of net revenues 2 % 0 % 0 %
During 2003, 2002 and 2001, we recorded impairment charges totaling $1.2 million, $3.8 million and $16.2 million, respectively, as a result of the deterioration of the financial condition of certain of our private and public equity investees. We identified these impairment losses as part of our normal process of assessing the quality of our investment portfolio. They reflect declines in fair value and other market conditions that we believe are other than temporary. We expect that the fair value of our equity investments will fluctuate from time to time and future impairment assessments may result in additional charges to our operating results.
Provision for Income Taxes
Percent Percent
2001 Change 2002 Change 2003
---------- --------- ----------- --------- -----------
(in thousands, except percent changes) Provision for income taxes $ 80,009 82 % $ 145,946 42 % $ 206,738 As a percentage of net revenues 11 % 12 % 10 % Effective tax rate 47 % 37 % 32 %
The provision for income taxes differs from the amount computed by applying the statutory U.S. federal rate principally due to non-deductible expenses related to acquisitions, state taxes, subsidiary losses for which we have not provided a benefit and other factors that increase the effective tax rate. These expenses are partially offset by decreases resulting from foreign income with lower effective tax rates, tax credits, and tax-exempt interest income.
The lower effective tax rates in 2003 and 2002 reflect the increasing profit contribution from our international operations that have lower effective tax rates.
We receive tax deductions from the gains realized by employees on the exercise of certain non-qualified stock options for which the benefit is recognized as a component of stockholders' equity. We have evaluated our deferred tax assets relating to these stock option deductions along with our other deferred tax assets and concluded that a valuation allowance is required for that portion of the total deferred tax assets that are not considered more likely than not to be realized in future periods. To the extent that the deferred tax assets with a full valuation allowance become realizable in future periods, we will have the ability, subject to carryforward limitations, to use up to $165.8 million of additional deferred tax assets to reduce future income tax liabilities. When recognized, the tax benefit of tax deductions related to stock options are accounted for as a credit to additional paid-in capital rather than a reduction of the income tax provision.
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Minority Interests
Percent Percent
2001 Change 2002 Change 2003
--------- --------- ---------- --------- ----------
(in thousands, except percent changes)
Minority interests $ 7,514 (131 )% $ (2,296 ) (230 )% $ (7,578 )
As a percentage of net revenue 1 % 0 % 0 %
Minority interests in consolidated companies represents the minority investors' percentage share of income or losses from subsidiaries in which we hold a majority ownership interest and consolidate the subsidiaries' results in our financial statements. Third parties held minority interests in various of our subsidiaries during 2003, 2002 and 2001.
The change in minority interests in 2003 is due primarily to the minority interests' portion of the net income generated by Internet Auction. We expect that minority interests will continue to fluctuate in future periods. If Internet Auction continues to be profitable, the minority interests adjustment on the consolidated statement of income will continue to decrease our net income by the minority investor's share of Internet Auction's net income.
The change in minority interests in 2002 primarily resulted from Internet Auction generating net income for the first time in 2002 along with our January 2002 acquisition of the remaining 35% minority interest in Billpoint.
Cumulative Effect of Change in Accounting Principle
In accordance with the provisions of FIN 46, "Consolidation of Variable Interest Entities," we have included our San Jose headquarters lease arrangement in our Consolidated Financial Statements effective July 1, 2003. Under this new accounting standard, our balance sheet at December 31, 2003, reflects additions for land and buildings totaling $126.4 million, lease obligations of $122.5 million and non-controlling minority interests of $3.9 million. Our income statement for the year ended December 31, 2003, reflects the reclassification of lease payments on our San Jose headquarters from operating expense to interest expense, beginning with the quarters following our adoption of FIN 46 on July 1, 2003, a $5.4 million after-tax charge for cumulative depreciation for periods from lease inception through June 30, 2003, and incremental depreciation expense of approximately $400,000, net of tax, per quarter for the third and fourth quarters of 2003. We have adopted the provisions of FIN 46 prospectively from July 1, 2003, and as a result, have not restated prior periods. The cumulative effect of the change in accounting principle arising from the adoption of FIN 46 has been reflected in net income in 2003.
Impact of Foreign Currency Translation
During 2003, our international net revenues, based upon the country in which the seller, payment recipient, advertiser or other service provider is located, accounted for 35% of our consolidated net revenues, as compared to 26% of our net revenues in 2002 and 15% of our net revenues in 2001. The growth in our international operations has increased our exposure to foreign currency fluctuations. Net revenues and related expenses generated from international locations are denominated in the functional currencies of the local countries, and include Euros, British Pounds, Korean Won, Canadian Dollars and Australian Dollars. The results of operations and certain of our intercompany balances associated with our international locations are exposed to foreign exchange rate fluctuations. The income statements of our international operations are translated into U.S. dollars at the average exchange rates in each applicable period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions results in increased net revenues, operating expenses and net income. Similarly, our net revenues, operating expenses and net income will decrease when the U.S. dollar strengthens against foreign currencies.
A significant portion of our international net revenues, operating expenses and net income are denominated in Euros. During 2003, the U.S. dollar weakened against the Euro. The weighted-average
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translation rate changes for the Euro, combined with translation rate changes in other foreign currencies, resulted in increased net revenues of approximately $82.0 million in 2003 when compared to the weighted-average foreign currency exchange rates used in the preparation of our consolidated financial statements in 2002. In addition, the weighted-average translation rate changes in foreign currencies increased operating expenses by approximately $37.9 million in 2003 when compared to the weighted average translation rates used in 2002.
We expect our international operations will continue to grow in significance as we develop and deploy our global marketplace. As a result, foreign currency fluctuations in future periods could become more significant and may have a negative impact on our net revenues and net income. See the information in Item 7A under "Foreign Currency Risk" for additional discussion of the impact of foreign currency translation and related hedging activities.
Liquidity and Capital Resources
Cash Flows
Year Ended December 31,
---------------------------------------------------------------
2001 2002 2003
----------------- ------------------ --------------------
(in thousands)
Net cash provided by (used in):
Operating activities $ 252,112 $ 479,903 $ 874,119
Investing activities (29,819 ) (157,759 ) (1,319,542 )
Financing activities 101,505 252,067 688,866
Effect of exchange rates on cash and cash
equivalents (1,702 ) 11,133 28,757
------- -------- ----------
Net increase in cash and cash
equivalents $ 322,096 $ 585,344 $ 272,200
------- -------- ----------
We have generated annual cash provided by operating activities in amounts greater than net income in 2001, 2002 and 2003, driven mainly by non cash charges to earnings. Non-cash charges to earnings included depreciation and amortization on our long-term assets, tax benefits on the exercise of employee stock options resulting from our increasing stock price and the related increases in the personal gains recognized by our employees, provision for doubtful accounts and authorized credits resulting from increasing revenues, provision for transaction losses resulting from increased total payment volumes processed by our PayPal subsidiary and other costs. In 2001, operating cash flows were partially offset by cash used to support working capital needs. In 2002 and 2003, operating cash flows were positively impacted by the net cash amounts provided by year-over-year changes in working capital assets and liabilities. During 2003, we used net cash provided by operating and financing activities to fund purchases of property and equipment, acquisitions and repayments of borrowings. Net cash provided by operating activities also contributed to an increase in our aggregate cash, cash equivalents and investments balance by $979.8 million in 2003 to approximately $2.8 billion. We currently expect that fiscal 2004 cash flows from operations will continue to exceed net income. We believe that existing cash, cash equivalents and investments, together with any cash generated from operations, will be sufficient to fund our operating activities, capital expenditures and other obligations for the foreseeable future. However, if during that period or thereafter we are not successful in generating sufficient cash flows from operations or in raising additional capital when required in sufficient amounts and on terms acceptable to us, our business could suffer.
The net cash flows used in investing activities in 2001, 2002 and 2003 were due primarily to the movement of cash between cash and investments, the purchase of property and equipment, and acquisitions. Purchases of property and equipment totaled $57.4 million in 2001, $138.7 million in 2002 and $365.4 million in 2003. Purchases of property and equipment in 2001 and 2002 related mainly to purchases of computer equipment and software to support our site operations, customer support and
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international expansion. In 2003, purchases of property and equipment included the $125.1 million purchase of additional office space in San Jose, California. Purchases of property and equipment in 2003 also included amounts for improvements to various facilities in the U.S. and around the world as well as computer equipment and software to support our site operations, customer support and international expansion. We expect capital expenditures for the purchase of property and equipment to approximate $250 million during 2004, without taking into account any acquisitions or other costs associated with the potential purchase of additional facilities. This amount for 2004 consists primarily of hardware and software for our platform architecture, site operations and corporate information systems. Cash expended for acquisitions, net of cash acquired, totaled $111.7 million in 2001, $59.4 million in 2002 and $216.4 million in 2003. In 2001, we expended cash to acquire a controlling interest in Internet Auction, located in South Korea. Our cash acquisitions in 2002 included acquiring the remaining ownership interest in our Billpoint subsidiary and a 38% interest in EachNet, located in China. We completed our acquisition of PayPal during 2002 through the exchange of our common stock, and we did not include cash payments in the purchase price. Our cash acquisitions in 2003 included acquiring the remaining ownership interest in EachNet and an additional ownership interest in Internet Auction Co.
The net cash flows provided by financing activities in 2001, 2002 and 2003 were due primarily to proceeds from stock option exercises. Proceeds from stock option exercises totaled $123.7 million in 2001, $252.2 million in 2002 and $700.8 million in 2003. Our future cash flows from stock options are difficult to project as such amounts are a function of both our stock price and the decisions by employees to exercise stock options. In general, we expect proceeds from stock option exercises to increase during periods in which our stock price has increased.
Commitments and Contingencies
The contractual obligations presented in the table below represent our estimates of future payments under fixed contractual obligations and commitments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows. The following table summarizes our fixed contractual obligations and commitments (in thousands):
Other
Year Ending Capital Operating Purchase
December 31, Leases Leases Obligations Total
------------ ----------- ----------- -------------- -----------
2004 $ 2,840 $ 22,765 $ 265,237 $ 290,842
2005 128,376 17,556 162,912 308,844
2006 11,693 54,580 66,273
2007 9,724 7,601 17,325
2008 9,661 749 10,410
Thereafter 44,361 44,361
------- ------- --------- -------
$ 131,216 $ 115,760 $ 491,079 $ 738,055
------- ------- --------- -------
Capital lease amounts include leases obligations associated with computer and other office equipment. The amounts presented are consistent with contractual terms and are not expected to differ significantly, unless we decide to purchase the individual assets prior to the end of the respective lease terms. The purchase obligation amount in 2005 also includes the assumed purchase of the corporate headquarters in San Jose, California, in March 2005, when the lease is scheduled to expire. See "Note 17 Subsequent Events" in the notes to the Consolidated Financial Statements.
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Operating lease amounts include minimum rental payments under our non-cancelable operating leases for office facilities, including our corporate headquarters located in San Jose, California, as well as limited computer and office equipment that we utilize under lease arrangements. The amounts presented are consistent with contractual terms and are not expected to differ significantly, unless a substantial change in our headcount needs requires us to exit an office facility early or expand our occupied space.
Other purchase obligation amounts include minimum purchase commitments for advertising, computer equipment, software applications, engineering development services and other goods and services that were entered into through our ordinary course of business. For those contractual arrangements in which there are significant performance requirements, we have developed estimates to project expected payment obligations. These estimates have been developed based upon historical trends, when available, and our anticipated future obligations. Given the significance of such performance requirements within our advertising and other arrangements, actual payments could differ significantly from these estimates.
Indemnification Provisions
During the ordinary course of business, in certain limited circumstances, we have included indemnification provisions within certain of our contracts. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally parties with which we have commercial relations, in connection with certain intellectual property infringement claims by any third party with respect to our services. To date, we have not incurred any costs in connection with such indemnification clauses.
Subsequent Events
On January 26, 2004, we entered into an agreement with mobile.de to acquire all of its outstanding shares for 121 million Euros (approximately $153 million at the January 26, 2004 exchange rate), subject to certain closing adjustments, plus acquisition costs. mobile.de is a classifieds website for vehicles in Germany. The acquisition, which is subject to regulatory approval in Germany by the Federal Cartel Office, is expected to close in the second quarter of 2004. The acquisition will be accounted for using the purchase method of accounting.
In February 2004, we elected not to exercise certain rights to extend the lease period for our San Jose corporate headquarters. The lease on these facilities will end on March 1, 2005, and we are obligated to make payments to the lessor of $126.4 million at lease expiration.
Critical Accounting Policies, Judgments and Estimates
General
The preparation of our Consolidated Financial Statements and related notes requires us to make judgments, estimates, and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We have based our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our senior management has discussed the development, selection and disclosure of these estimates with the Audit Committee of our Board of Directors. Actual results may differ from these estimates under different assumptions or conditions.
An accounting policy is considered to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. We believe the following critical accounting policies reflect the more significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. The following descriptions of critical accounting
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policies, judgments and estimates should be read in conjunction with our Consolidated Financial Statements and other disclosures included in this report.
Provisions for Doubtful Accounts and Authorized Credits
Our U.S. and International segments are exposed to losses due to uncollectible accounts and credits to sellers. Provisions for these items represent our estimate of actual losses and credits based on our historical experience, are monitored monthly, and are made at the time the related revenue is recognized. The provision for doubtful accounts is recorded as a charge to operating expense, while the authorized credits are recorded as a reduction of revenues. The following table illustrates the provision related to doubtful accounts and authorized credits as a percentage of net revenues for 2001, 2002, and 2003 (in thousands, except percents).
Years Ended December 31,
------------------------------------------------------------
2001 2002 2003
--------------- ------------------- ------------------
Net revenues from the U.S. and International
segments $ 731,173 $ 1,118,732 $ 1,727,474
Provision for doubtful accounts and authorized
credits 25,243 25,455 46,049
Provision for doubtful accounts and authorized
credits as a % of net revenues from the U.S. and
International segments 3.5% 2.3% 2.7%
Historically, our actual losses and credits have been consistent with these provisions. However, unexpected or significant future changes in trends could result in a material impact to future statements of income and cash flows. Based on our results for the year ended December 31, 2003, a 25 basis point deviation from our estimates would have resulted in an increase or decrease in operating expenses and/or net revenues of approximately $4.3 million. The following analysis demonstrates, for illustrative purposes only, the potential effect a 25 basis point deviation from our estimates would have upon our Consolidated Financial Statements and is not intended to provide a range of exposure or expected deviation (in thousands, except per share data):
Our
-25 Basis 2003 +25 Basis
Points Estimate Points
----------------- --------------- ----------------
Expense/revenue reduction related to doubtful
accounts and authorized credits $ 41,731 $ 46,049 $ 50,368
Income from operations 633,559 629,241 624,922
Net income 444,722 441,771 438,816
Diluted earnings per share 0.68 0.67 0.67
Provision for Transaction Losses
Our Payments segment is exposed to transaction losses due to credit card and other payment misuse, as well as non-performance of sellers who accept payment through PayPal. We establish allowances for estimated losses arising from processing customer transactions, such as charge-backs for unauthorized credit card use and merchant-related charge-backs due to non-delivery of goods or services, ACH returns, and debit card overdrafts. These allowances represent an accumulation of the estimated amounts, using an actuarial technique, necessary to provide for transaction losses incurred as of the reporting date, including those of which we have not yet been notified. The allowances are monitored monthly and are updated based on actual claims data reported by our claims processors. Customers typically have up to 180 days to file transaction disputes. Consequently, the time between estimating the loss provisions and realization of the actual amount is short. The allowances are based on known facts and circumstances, internal factors including our experience with similar cases, historical trends involving loss payment patterns and the mix of transaction and loss types. Additions to the allowance, in the form of provisions, are reflected as a
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general and administrative expense in our results of operations, while write-offs to the allowance are made when a loss is determined to have occurred. Recoveries, when collected, are recorded as an increase to the allowance for transaction losses. As of December 31, 2003, the allowance for transaction losses totaled $12.0 million and was included in accrued expenses and other current liabilities in our consolidated balance sheet.
The following table illustrates the provision for transaction loss expense as a percentage of total payment volume from PayPal operations for the period from October 3, 2002 through December 31, 2002 and for the year ended December 31, 2003 (in thousands, except percents).
Period from
October 3, 2002
through Year Ended
December 31, 2002 December 31, 2003
------------------- --------------------
Total payment volume $ 2,138,093 $ 12,226,305
Transaction loss expense 7,832 36,401
As a % of total payment volume 0.37% 0.30%
The establishment of appropriate allowances for transaction losses is an inherently uncertain process, and ultimate losses may vary from the current estimates. We regularly update our allowance estimates as new facts become known and events occur that may impact the settlement or recovery of losses. The allowances are maintained at a level we deem appropriate to adequately provide for losses incurred at the balance sheet date. Based on our results for the year ended December 31, 2003, a five basis point deviation from our estimates would have resulted in an increase or decrease in our operating expenses of approximately $6.1 million. The following analysis demonstrates, for illustrative purposes only, the potential effect a five basis point deviation from our estimates would have upon our Consolidated Financial Statements for the year ended December 31, 2003, and is not intended to provide a range of exposure or expected deviation (in thousands, except per share data):
Our
-5 Basis 2003 +5 Basis
Points Estimate Points
----------- ----------- -----------
Transaction loss expense $ 30,288 $ 36,401 $ 42,515
Income from operations 635,354 629,241 623,127
Net income 445,949 441,711 437,588
Diluted earnings per share 0.68 0.67 0.67
Legal Contingencies
In connection with certain pending litigation and other claims, we have estimated the range of probable loss and provided for such losses through charges to our income statement. These estimates have been based on our assessment of the facts and circumstances at each balance sheet date and are subject to change based upon new information and future events.
From time to time, we are involved in disputes that arise in the ordinary course of business, and we do not expect this trend to change in the future. We are currently involved in certain legal proceedings as discussed in "Item 3: Legal Proceedings" and "Note 11 Commitments and Contingencies Litigation and Other Legal Matters" to our Consolidated Financial Statements, which we incorporate by reference herein. We believe that we have meritorious defenses to the claims against us, and we will defend ourselves vigorously. However, even if successful, our defense against certain actions will be costly and could divert our management's time. If the plaintiffs were to prevail on certain claims, we might be forced to pay significant damages and licensing fees, modify our business practices or even be prohibited from conducting a significant part of our U.S. business. Any such results could materially harm our business and
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could result in a material adverse impact on the financial position, results of operations or cash flows of all or any of our three segments.
Accounting for Income Taxes
We are required to recognize a provision for income taxes based upon the taxable income and temporary differences for each of the tax jurisdictions in which we operate. This process requires a calculation of taxes payable under currently enacted tax laws around the world and an analysis of temporary differences between the book and tax bases of our assets and liabilities, including various accruals, allowances, depreciation and amortization. The tax effect of these temporary differences and the estimated tax benefit from our tax net operating losses are reported as deferred tax assets and liabilities in our consolidated balance sheet. We also assess the likelihood that our net deferred tax assets will be realized from future taxable income. To the extent we believe that it is more likely than not that some portion, or all of, the deferred tax asset will not be realized, we establish a valuation allowance. To the extent we establish a valuation allowance or change the allowance in a period, we reflect the change with a corresponding increase or decrease in our tax provision in our income statement. Where the change in the valuation allowance relates to the deduction for employee stock option exercises, the change is reflected as a credit to additional paid-in capital. As employee stock option exercises are highly dependent upon our stock price, it is extremely difficult to predict the amount of deductions that will be generated from future option exercises and, therefore, for us to ascertain the amount of deferred tax assets related to employee stock option exercises that may be realized in future periods. The deferred tax asset, net of a valuation allowance of $165.8 million, totaled $52.0 million at December 31, 2003 and was offset by deferred tax liabilities of $107.1 million resulting in a net deferred tax liability of $55.1 million. In addition, due to our significant anticipated international expansion, we have not provided for U.S. federal income and foreign withholding taxes on non-U.S. subsidiaries' undistributed earnings as of December 31, 2003, because such earnings are intended to be reinvested indefinitely. In the event that our future international expansion plans change and such amounts are not reinvested indefinitely, we would be subject to U.S. income taxes partially offset by foreign tax credits. The following table illustrates the provision for income taxes as a percentage of income before income taxes for 2001, 2002, and 2003 (in thousands, except percents):
Year Ended December 31,
---------------------------------------
2001 2002 2003
----------- ----------- -----------
Income before income taxes $ 170,457 $ 395,837 $ 653,922
Provision for income taxes 80,009 145,946 206,738
As a % of income before income taxes 47% 37% 32%
Historically, these provisions have adequately provided for our actual income tax liabilities. However, unexpected or significant future changes in trends could result in a material impact to future statements of income and cash flows. Based on our results for the year ended December 31, 2003, a one-percentage point change in our provision for income taxes as a percentage of income before taxes would have resulted in an increase or decrease in expense of approximately $6.5 million. The following analysis demonstrates, for illustrative purposes only, the potential effect such a one-percentage point deviation change would have upon our financial statements and is not intended to provide a range of exposure or expected deviation (in thousands, except per share data):
Our
2003
-1% Estimate +1%
----------- ----------- -----------
Provision for income taxes $ 200,199 $ 206,738 $ 213,277
Income before income taxes 653,922 653,922 653,922
Net income 448,310 441,771 435,232
Diluted earnings per share 0.68 0.67 0.66
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Advertising and Other Non-Transaction Revenues
A portion of our net revenues result from fees associated with advertising and other non-transaction services in our U.S., International and Payments segments. Net revenues from advertising are derived principally from the sale of online banner and sponsorship advertisements for cash and through barter arrangements. Other non-transaction net revenues are derived principally from contractual arrangements with third parties that provide transaction services to eBay users and from offline services provided by wholly-owned subsidiaries that were divested in the second half of 2002. Advertising and other non-transaction net revenues, including barter transactions, totaled 20%, 9% and 2% of our consolidated net revenues for the years ended December 31, 2001, 2002 and 2003, respectively, and were primarily generated by our U.S. segment. Revenue from barter arrangements totaled $10.4 million in 2001, $10.1 million in 2002 and $10.1 million in 2003. Certain judgments are involved in the determination of the appropriate revenue recognition, including, but not limited to, the assessment and allocation of fair values in multiple element arrangements and the appropriateness of gross or net revenue recognition. Our advertising and other non-transaction net revenues may be affected by the financial condition of the parties with whom we have these relationships and by the success of online services and promotions in general. Unlike our transaction revenues, advertising and other non-transaction net revenues are derived from a highly concentrated customer base. During the years ended December 31, 2001, 2002 and 2003, all advertising and other non-transaction net revenues, excluding offline revenues, were derived from approximately 40, 50 and 110 customers, respectively.
Business Combinations
In accordance with the provisions of SFAS 141, the purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual of the purchase price recorded as goodwill. The determination of the value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future, the appropriate weighted average cost of capital, and the cost savings expected to be derived from acquiring an asset.
At December 31, 2003 our goodwill totaled $1.7 billion and our identifiable intangible assets totaled $274.1 million. In accordance with the provisions of SFAS 142, we assess the impairment of goodwill and identifiable intangible assets of our reportable units annually, or more often if events or changes in circumstances indicate that the carrying value may not be recoverable. This assessment is based upon a discounted cash flow analysis and analysis of our market capitalization. The estimate of cash flow is based upon, among other things, certain assumptions about expected future operating performance and an appropriate discount rate determined by our management. Our estimates of discounted cash flows may differ from actual cash flows due to, among other things, economic conditions, changes to its business model or changes in operating performance. Significant differences between these estimates and actual cash flows could materially affect our future financial results. We completed our annual goodwill impairment test as of August 31, 2003 and determined that no adjustment to the carrying value of goodwill for any of our reportable units was required. We have determined that no events have occurred during the four months ended December 31, 2003 that would require updated analysis.
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Risk Factors That May Affect Results of Operations and Financial Condition
The risks and uncertainties described below are not the only ones facing eBay. Other events that we do not currently anticipate or that we currently deem immaterial also may impair our business operations.
Our operating results may fluctuate.
Our operating results have varied on a quarterly basis during our operating history. Our operating results may fluctuate significantly as a result of a variety of factors, many of which are outside our control. Factors that may affect our quarterly operating results include the following:
our ability to retain an active user base, to attract new users and to encourage existing users to list items for sale, purchase items through our service, or use our payment services, both in the U.S. and internationally;
the amount and timing of operating costs and capital expenditures relating
to the maintenance and expansion of our businesses, operations, and
infrastructure;
foreign or domestic government regulation, including investigations prompted
by items listed, sold, or paid for by our users; our ability to comply with the requirements of entities whose services are
required for our operations, such as credit card associations; the success of our geographic and product expansion;
the introduction of new sites, services, and products by us or our
competitors; volume, size, timing, and completion rate of transactions on our websites;
consumer confidence in the safety and security of transactions on our
websites; the costs and results of litigation that involves us;
our ability to upgrade and develop our systems, infrastructure, and customer
service capabilities to accommodate growth at a reasonable cost; our ability to keep our websites operational at a reasonable cost;
our ability to develop product enhancements at a reasonable cost and to
develop programs and features in a timely manner; our ability to integrate successfully and cost effectively manage our
acquisitions, including PayPal and, more recently, EachNet; our ability to manage PayPal's transaction loss and credit card chargeback
rate and payment funding mix; our ability to expand PayPal's product offerings internationally (including
our ability to obtain any necessary regulatory approvals) and to increase
the acceptance of PayPal by online merchants outside of the eBay
marketplace;
our ability to attract new personnel in a timely and effective manner;
our ability to retain key employees in our businesses;
our ability to expand our product offerings involving fixed-price trading;
the results of regulatory decisions that affect us;
technical difficulties or service interruptions involving our websites or
services provided to our users by third parties; the actions of our competitors;
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the timing, cost and availability of advertising in traditional media and on
other websites and online services; the timing of payments to us and of marketing and other expenses under
existing and future contracts; the success of our brand building and marketing campaigns;
the continued financial strength of our technology suppliers and other
parties with which we have commercial relations; increasing consumer acceptance of the Internet and other online services for
commerce and, in particular, for the trading of products such as those
listed on our websites;
general economic conditions and those economic conditions specific to the
Internet and e-commerce industries; and geopolitical events such as war, threat of war, or terrorist actions.
Our limited operating history and the increased variety of services offered on our websites make it difficult for us to forecast the level or source of our revenues or earnings accurately. In view of the rapidly evolving nature of our business and our limited operating history, we believe that period-to-period comparisons of our operating results may not be meaningful, and you should not rely upon them as an indication of future performance. We do not have backlog, and substantially all of our net revenues each quarter come from transactions involving sales or payments during that quarter. Due to the inherent difficulty in forecasting revenues it is also difficult to forecast income statement expenses as a percentage of net revenues. Quarterly and annual income statement expenses as a percentage of net revenues may be significantly different from historical or projected rates. Our operating results in one or more future quarters may fall below the expectations of securities analysts and investors. In that event, the trading price of our common stock would almost certainly decline.
We may not maintain our level of profitability.
We believe that our continued profitability at historical levels will depend in large part on our ability to do the following:
attract new users and keep existing users active on our websites;
manage the costs of our business, including the costs associated with maintaining and developing our websites, customer support, transaction and
chargeback rates, and international and product expansion; maintain sufficient transaction volume to attract buyers and sellers;
increase the awareness of our brands; and
provide our customers with superior community, customer support, and trading
experiences.
We invest heavily in marketing and promotion, customer support, and further development of operating infrastructure for our core and recently acquired operations. Some of this investment entails long-term contractual commitments. As a result, we may be unable to adjust our spending rapidly enough to compensate for any unexpected revenue shortfall, which may harm our profitability. In addition, we are spending in advance of anticipated growth, which may also harm our profitability.
There are many risks associated with our international operations.
Our international expansion has been rapid and we have only limited experience in many of the countries in which we now do business. Our international business, especially in Germany, the U.K., Canada, and South Korea, has also become critical to our revenues and profits. Expansion into international markets, such as our recent entry into the People's Republic of China, requires management
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attention and resources. We have limited experience in localizing our service to conform to local cultures, standards and policies. In many countries, we compete with local companies who understand the local market better than we do. We may not be successful in expanding into particular international markets or in generating revenues from foreign operations. For example, in 2002 we withdrew from the Japanese market. Even if we are successful, we expect the costs of operating new sites to exceed our net revenues for at least 12 months in most countries. As we continue to expand internationally, including through the expansion of PayPal, we are subject to risks of doing business internationally, including the following:
regulatory requirements, including regulation of auctioneering, professional selling, distance selling, banking, and money transmitting, that may limit
or prevent the offering of eBay's and PayPal's services in some
jurisdictions, prevent enforceable agreements between sellers and buyers,
prohibit the listing of certain categories of goods, require special
licensure, or limit the transfer of information between eBay and our
affiliates;
legal uncertainty regarding liability for the listings and other content
provided by our users, including uncertainty as a result of less
Internet-friendly legal systems, unique local laws, and lack of clear
precedent or applicable law;
difficulties in integrating with local payment providers, including banks,
credit and debit card associations and electronic fund transfer systems; different employee/employer relationships and the existence of workers'
councils and labor unions; difficulties in staffing and managing foreign operations;
longer payment cycles, different accounting practices, and greater problems
in collecting accounts receivable; potentially adverse tax consequences, including local taxation of our fees
or of transactions on our websites; higher telecommunications and Internet service provider costs;
strong local competitors;
different and more stringent consumer protection, data protection and other
laws; cultural ambivalence towards, or non-acceptance of, online trading;
seasonal reductions in business activity;
expenses associated with localizing our products, including offering
customers the ability to transact business in the local currency; laws and business practices that favor local competitors;
profit repatriation restrictions, foreign currency exchange restrictions,
and exchange rate fluctuations; changes in a specific country's or region's political or economic
conditions; and differing intellectual property laws.
Some of these factors may cause our international costs of doing business to exceed our comparable domestic costs. To the extent we expand our international operations and have additional portions of our international revenues denominated in foreign currencies, we also could become subject to increased difficulties in collecting accounts receivable and risks relating to foreign currency exchange rate fluctuations. The impact of currency exchange rate fluctuations is discussed in more detail under "We are exposed to fluctuations in currency exchange rates," below.
We intend to expand PayPal's services internationally. Both eBay and PayPal have limited experience with the payments business outside of the U.S. In some countries, expansion of PayPal's business may require a close commercial relationship with one or more local banks. We do not know if these or other
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factors may prevent, delay, or limit PayPal's expansion or reduce its profitability. Any limitation on our ability to expand PayPal internationally could harm our business.
Our investment in EachNet is subject to risks and uncertainties relating to the laws and regulations of the People's Republic of China.
In July 2003, we completed the acquisition of the remaining outstanding capital stock and options of EachNet. EachNet is a Delaware corporation and a foreign person under the laws of the People's Republic of China, or PRC, and is subject to many of the risks of doing business internationally described above under "There are many risks associated with our international operations." The PRC currently regulates its Internet sector through regulations restricting the scope of foreign investment and through the enforcement of content restrictions on the Internet. While many aspects of these regulations remain unclear, they purport to limit and require licensing of various aspects of the provision of Internet information services. These regulations have created substantial uncertainties regarding the legality of foreign investments in PRC Internet companies, including EachNet and the business operations of such companies. In order to meet local ownership and regulatory licensing requirements, the EachNet website is operated through a foreign-owned enterprise indirectly owned by EachNet Inc., which acts in cooperation with a local PRC company owned by certain EachNet employees. We believe EachNet's current ownership structure complies with all existing PRC laws, rules, and regulations. There are, however, substantial uncertainties regarding the interpretation of current PRC laws and regulations, and it is possible that the PRC government will ultimately take a view contrary to ours. There are also uncertainties regarding EachNet's ability to enforce contractual relationships it has entered into with respect to management and control of the company's business. If EachNet were found to be in violation of any existing or future PRC laws or regulations, it could be subject to fines and other financial penalties, have its business and Internet content provider licenses revoked, or be forced to discontinue its business entirely.
We are exposed to fluctuations in currency exchange rates.
Net revenues outside the United States accounted for approximately 35% of our net revenues in 2003. Because we conduct a significant and growing portion of our business outside the United States, we face exposure to adverse movements in non-U.S. currency exchange rates. In connection with its multi-currency service, PayPal fixes exchange rates twice per day, and may face financial exposure if it incorrectly fixes the exchange rate. PayPal also holds some corporate funds in non-U.S. currencies to facilitate customer withdrawals, and thus its financial results are affected by the translation of these non-U.S. currencies into U.S. dollars. In addition, the results of operations of our internationally focused websites are exposed to foreign exchange rate fluctuations as the financial results of the applicable subsidiaries are translated from the local currency into U.S. dollars upon consolidation. If the U.S. dollar weakens against foreign currencies, as it did during 2003, the translation of these foreign-currency-denominated transactions will result in increased net revenues, operating expenses, and net income. The change in weighted average foreign currency exchange rates in 2003 relative to the comparable rates used in preparation of our consolidated 2002 financial statements resulted in an increase in net revenue of approximately $82.0 million and an increase in operating expenses of approximately $37.9 million. Similarly, our net revenues, operating expenses, and net income will decrease if the U.S. dollar strengthens against foreign currencies. As exchange rates vary, net sales and other operating results, when translated, may differ materially from expectations. In particular, to the extent the U.S. dollar strengthens against the Euro and British Pound, our European revenues and profits will be reduced as a result of these translation adjustments.
Our business may be subject to sales and other taxes.
We do not collect sales or other similar taxes on goods or services sold by users through our services. One or more states or any foreign country may seek to impose sales, use, or value-added tax collection or record-keeping obligations on companies such as eBay that engage in or facilitate online commerce. Such taxes could be imposed if, for example, we were ever deemed to be an auctioneer or the agent of our
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sellers. Several proposals have been made at the state and local level that would impose additional taxes on the sale of goods and services through the Internet. These proposals, if adopted, could substantially impair the growth of e-commerce, and could diminish our opportunity to derive financial benefit from our activities. In 1998 and 2000, the U.S. federal government enacted legislation prohibiting states or other local authorities from imposing access or discriminatory taxes on the Internet through November 1, 2003. The expiration of this moratorium may permit new access or discriminatory taxes on the Internet that could adversely affect our business. Legislation has also been introduced in the U.S. Congress to override the Supreme Court's Quill decision, which limits the ability of state governments to require sellers outside of their own state to collect and remit sales taxes on goods purchased by in-state residents. Passage of such legislation and the imposition of such sales tax requirements would adversely affect our sellers and our business. On July 1, 2003, eBay began collecting value-added tax, or VAT, on the fees we charge sellers in the European Union, or EU. We continue to work with the relevant tax authorities to clarify our obligations under these new regulations. There have been and will continue to be substantial ongoing costs associated with complying with the VAT rules throughout the EU, and the increased costs to our European users may reduce their activity on our websites and could adversely affect our international transaction net revenues. A successful assertion by one or more states or any foreign country that we should collect sales or other taxes on the exchange of merchandise or services on our system would harm our business.
Our business may be harmed by fraudulent activities on our websites and disputes between users of our services.
PayPal faces significant risks of loss due to fraud and disputes between senders and recipients, including:
merchant fraud and other disputes over the quality of goods and services;
unauthorized use of credit card and bank account information and identity
theft; the need to provide effective customer support to process disputes between
senders and recipients; potential breaches of system security;
potential employee fraud; and
use of PayPal's system by customers to make or accept payment for illegal or
improper purposes.
For the year ended December 31, 2003, PayPal's provision for transaction losses totaled $36.4 million, representing 0.30% of PayPal's total payment volume. Failure to deal effectively with fraudulent transactions and customer disputes would increase PayPal's loss rate and harm its business.
The highly automated nature of, and liquidity offered by, PayPal's payment service makes PayPal an attractive target for fraud. In configuring its service, PayPal faces an inherent trade-off between customer convenience and security. Identity thieves and those committing fraud using stolen credit card or bank account numbers, often in bulk and in conjunction with automated mechanisms of online communication, potentially can steal large amounts of money from businesses such as PayPal's. We believe that several of PayPal's current and former competitors in the electronic payments business have gone out of business or significantly restricted their businesses largely due to losses from this type of fraud. We expect that technically knowledgeable criminals will continue to attempt to circumvent PayPal's anti-fraud systems. In addition, PayPal's service could be subject to employee fraud or other internal security breaches, and PayPal is required to reimburse customers for any funds stolen as a result of such breaches. If PayPal fails to prevent external or internal fraud, our business will be harmed.
PayPal incurs substantial losses from merchant fraud, including claims from customers that merchants have not performed or that their goods or services do not match the merchant's description. PayPal also incurs losses from claims that the customer did not authorize the purchase, from erroneous transmissions and from customers who have closed bank accounts or have insufficient funds in them to satisfy payments. In addition to the direct costs of such losses, if they are related to credit card transactions and become
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excessive they could result in PayPal losing the right to accept credit cards for payment. If PayPal were unable to accept credit cards, the velocity of trade on eBay could decrease, in which case our business would further suffer. PayPal has been assessed substantial fines for excess chargebacks in the past, and excessive chargebacks may arise in the future. PayPal has taken measures to detect and reduce the risk of fraud, but these measures may not be effective. If these measures do not succeed, our business will suffer.
In addition, prior to September 2003, some card issuers treated purchases made through PayPal as the purchase of a money transfer service rather than the purchase of goods and services, which resulted in reduced chargeback rights for the consumer if the consumer did not receive the goods or received unsatisfactory goods. PayPal could be required to provide consumers full chargeback rights in such pre-September 2003 cases, even if the normal time for exercising chargeback rights has expired. PayPal must also now absorb the costs of chargebacks from all card issuers for goods that are not delivered or are not as described, which may result in increased losses from merchant fraud and from disputes over the quality of goods and services.
In October 2003, PayPal launched a new buyer protection program that will refund buyers up to $500 in certain eBay transactions if they do not receive the goods they purchased or if the goods are significantly not as described. In the event that PayPal makes such a refund, it will seek to collect reimbursement from the seller, but may not be able to receive any funds from the seller. The PayPal Buyer Protection program has increased PayPal's loss rate and could cause future fluctuations.
eBay faces similar risks to those of PayPal with respect to fraudulent activities, although eBay's risks may to some extent be less significant. eBay periodically receives complaints from users who did not receive the purchase price or the goods that were to have been exchanged. In some cases individuals have been arrested and convicted for fraudulent activities using our websites. While eBay can suspend the accounts of users who fail to fulfill their delivery obligations to other users, eBay does not have the ability to require users to make payments or deliver goods, or otherwise make users whole other than through our limited buyer protection programs. Other than through these programs, eBay does not compensate users who believe they have been defrauded by other users. eBay also periodically receives complaints from buyers as to the quality of the goods purchased. We expect to continue to receive communications from users requesting reimbursement or threatening or commencing legal action against us if no reimbursement is made. Our liability for these sort of claims is only beginning to be clarified and may be higher in some non-U.S. jurisdictions than it is in the U.S. Litigation of this sort could be costly for us, divert management attention, result in increased costs of doing business, lead to adverse judgments, or could otherwise harm our business. In addition, affected users will likely complain to regulatory agencies that could take action against us, including imposing fines or seeking injunctions.
Negative publicity generated as a result of fraudulent or deceptive conduct by users of our eBay and PayPal services is increasing, and such publicity could damage our reputation, reduce our ability to attract new users and diminish the value of our brand name.
PayPal's success in reducing fraud losses depends in part on its ability to restrict the withdrawal of customer funds while it investigates suspicious transactions. PayPal has been and could again be sued by plaintiffs and has received inquiries from governmental entities regarding its account restriction and disclosure practices. If the results of these lawsuits or inquiries are adverse to PayPal, it could be required to pay substantial damages and restructure its anti-fraud processes in ways that would harm its business.
As part of PayPal's program to reduce fraud losses, it may temporarily restrict the ability of customers to withdraw their funds if those funds or the customer's account activity are identified by PayPal's anti-fraud models as suspicious. PayPal is subject to purported class action lawsuits challenging its procedures and disclosures with respect to suspicious accounts, and alleging that those procedures and disclosures violate federal and state law on consumer protection and unfair business practice and are inconsistent with PayPal's user agreement. In addition, many customers who are subject to such restrictions complain to regulatory agencies. As a result of customer complaints, PayPal has also received inquiries regarding its
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restriction and disclosure practices from the Federal Trade Commission and the attorneys general of a number of states. If PayPal's processes are found to violate federal or state law on consumer protection and unfair business practices, it could be subject to an enforcement action or fines. If PayPal loses the litigation described above or becomes subject to an enforcement action, it could be required to restructure its anti-fraud processes in ways that would harm its business, and to pay substantial damages or fines. Even if PayPal is able to defend itself successfully, the litigation or enforcement action could cause damage to its reputation, could consume substantial amounts of its management's time and attention, and could require PayPal to change its customer service and operations in ways that could increase its costs and decrease the effectiveness of its anti-fraud program.
Changes to card association rules or practices could negatively affect PayPal's service and, if it does not comply with the rules, could result in a termination of PayPal's ability to accept credit cards. If PayPal is unable to accept credit cards, our business would suffer.
Because PayPal is not a bank, it cannot belong to or directly access the Visa and MasterCard credit card associations. As a result, PayPal must rely on banks or payment processors to process transactions. PayPal is required by its processors to comply with credit card association operating rules, and PayPal has agreed to reimburse its processors for any fines they are assessed by credit card associations as a result of processing payments for PayPal. The credit card associations and their member banks set and interpret the credit card rules. Some of those member banks compete with PayPal. Visa, MasterCard, American Express, or Discover could adopt new operating rules or re-interpret existing rules which PayPal and/or its processors might find difficult or even impossible to follow. As a result, PayPal could lose its ability to give customers the option of using credit cards to fund their payments. If PayPal were unable to accept credit cards, its business would be seriously damaged. In addition, the velocity of trade on eBay could decrease and our business would further suffer.
In 2002, both Visa and MasterCard adopted new operating rules for Internet payment services like PayPal. In order to comply with the associations' new rules, PayPal and its credit card processors have implemented changes to existing business processes for U.S. customers, and have worked aggressively throughout 2003 on changes with respect to processes for transactions involving international customers. PayPal and its processors completed the implementation of these changes with respect to Canadian and European customers in February 2004. Any problems with this implementation could result in fines, the amount of which would be within Visa's and MasterCard's discretion. PayPal and its processors could be unable to implement the necessary changes with respect to customers outside the U.S., Canada, and Europe, which could result in fines or the inability of PayPal to process MasterCard payments for international merchants in certain countries. PayPal also could be subject to fines from MasterCard and Visa if it fails to register and conduct additional monitoring with respect to the activities of merchants that are considered "high risk," primarily certain merchants that sell digital content. PayPal's credit card processors have passed on to PayPal fines of $50,000 in 2003 and $25,000 through March 1 in the first quarter of 2004 relating to PayPal's failure to detect the use of its service by certain "high risk" merchants using the PayPal service.
Increases in credit card processing fees could increase PayPal's costs, affect its profitability, or otherwise limit its operations.
From time to time, Visa, MasterCard, American Express and Discover may increase the interchange fees that they charge for each transaction using one of their cards. MasterCard and Visa have each announced increases to their credit card interchange fees effective April 2004. Visa and MasterCard both implemented a decrease in their debit card interchange fees in August 2003 as a result of the settlement of litigation, but the settlement agreement required them to maintain these lower interchange fees only until January 2004, and they have announced increases in debit card interchange fees, in January 2004 and April 2004, respectively, to levels close to those that prevailed prior to August 2003. PayPal's credit card processors have the right to pass any increases in interchange fees on to PayPal. Such increased fees will increase PayPal's operating costs and reduce its profit margins.
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If PayPal were found to be subject to or in violation of any U.S. laws or regulations governing banking, money transmission or electronic funds transfers, it could be subject to liability and forced to change its business practices.
We believe that the licensing or approval requirements of the U.S. Office of the Comptroller of the Currency, the Federal Reserve Board and other federal or state agencies that regulate banks, bank holding companies, or other types of providers of electronic commerce services do not apply to PayPal, except for certain money transmitter licenses mentioned below. However, one or more states may conclude that PayPal is engaged in an unauthorized banking business. PayPal received written communications from regulatory authorities in New York and Louisiana in early 2002 expressing the view that its service as it formerly operated constituted an unauthorized banking business, and from authorities in California and Idaho in 2001 that its service might constitute an unauthorized banking business. PayPal has taken steps to address these states' concerns and received a conclusion in 2002 from the New York Banking Department that its current business model does not constitute illegal banking. PayPal also has obtained licenses to operate as a money transmitter in California, Louisiana, Idaho and many other states. However, we cannot guarantee that the steps PayPal has taken to address state regulatory concerns will be effective in all states. If PayPal is found to be engaged in an unauthorized banking business in one or more states, it might be subject to monetary penalties and adverse publicity and might be required to cease doing business with residents of those states. Even if the steps it has taken to resolve these states' concerns are deemed sufficient by the state regulatory authorities, PayPal could be subject to fines and penalties for its prior activities. The need to comply with state laws prohibiting unauthorized banking activities could also limit PayPal's ability to enhance its services in the future. Any change to PayPal's business practices that makes the service less attractive to customers or prohibits its use by residents of a particular jurisdiction could decrease the velocity of trade on eBay, which would further harm our business.
A number of states have enacted legislation regulating money transmitters and PayPal has applied for licenses under this legislation in 31 jurisdictions. To date, PayPal has obtained licenses in 24 of these jurisdictions. As a licensed money transmitter, PayPal is subject to bonding requirements, restrictions on its investment of customer funds, reporting requirements, and inspection by state regulatory agencies. If PayPal's pending applications were denied, or if it were found to be subject to and in violation of any money services laws or regulations, PayPal also could be subject to liability, forced to cease doing business with residents of certain states, or forced to change its business practices. Any change to PayPal's business practices that makes the service less attractive to customers or prohibits its use by residents of a particular jurisdiction could decrease the velocity of trade on eBay, which would further harm our business. Even if PayPal is not forced to change its business practices, it could be required to obtain licenses or regulatory approvals that could impose a substantial cost on PayPal.
Although there have been no definitive interpretations to date, PayPal has assumed that its service is subject to the Electronic Fund Transfer Act and Regulation E of the Federal Reserve Board. As a result, among other things, PayPal must provide advance disclosure of changes to its service, follow specified error resolution procedures and absorb losses above $50 from transactions not authorized by the consumer. In addition, PayPal is subject to the financial privacy provisions of the Gramm-Leach-Bliley Act and related regulations. As a result, some customer financial information that PayPal receives is subject to limitations on reuse and disclosure. Existing and potential future privacy laws may limit PayPal's ability to develop new products and services that make use of data gathered through its service. The provisions of these laws and related regulations are complicated, and PayPal does not have extensive experience in complying with them. Even technical violations of these laws can result in penalties of up to $1,000 for each non-compliant transaction. During 2003, PayPal processed approximately 629,000 transactions per day, and any violations could expose PayPal to significant liability.
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PayPal's status under banking or financial services laws or other laws in countries outside the U.S. is unclear. The cost of obtaining any required licenses or regulatory approvals in these countries could affect PayPal's future profitability.
PayPal currently allows its customers with credit cards to send payments from 37 countries outside the U.S., and to receive payments in 32 of those countries. In 22 of these countries, customers can withdraw funds to local bank accounts. In the fourth quarter of 2002, PayPal began offering customers the ability to send or receive payments denominated in Pounds, Euros, Canadian Dollars or Yen, in addition to U.S. Dollars. In February 2004, PayPal (Europe) Ltd., a wholly-subsidiary of PayPal, received a license to operate as an Electronic Money Institution in the United Kingdom as a vehicle for providing localized versions of PayPal's service to customers in the European Union. PayPal has completed the migration of all EU customers to that subsidiary. Fifteen of the 37 countries whose residents can use the PayPal service are members of the European Union. As PayPal (Europe) develops localized services for the domestic market in these countries, it will seek approval to implement such localized service through an expedited "passport" notification process. Any delay in obtaining clearance through the "passport" process could force PayPal to delay its plans for expanding its business. PayPal has filed "passport" notices for Germany, France, Netherlands, Belgium and Austria. PayPal (Europe) is subject to significant fines or other enforcement action if it violates the disclosure, reporting, anti money laundering, capitalization, funds management or other requirements imposed on electronic money institutions.
In the 22 countries that are not members of the European Union, it is not clear whether PayPal's U.S.-based service is subject to local law or, if it is subject to local law, whether such local law requires a payment processor like PayPal to be licensed as a bank or financial institution or otherwise. Even if PayPal is not currently required to obtain a license in those countries, future localization or targeted marketing of PayPal's service in those countries could require licensure. Even if PayPal is not required to obtain a license, other laws of those countries (such as data protection laws) may apply. If PayPal were found to be subject to and in violation of any foreign laws or regulations, it could be subject to liability, forced to change its business practices or forced to suspend providing services to customers in one or more countries. Alternatively, PayPal could be required to obtain licenses or regulatory approvals that could impose a substantial cost on it and involve considerable delay to the provision or development of its product. Delay or failure to receive such a license would require PayPal to change its business practices or features in ways that would adversely affect PayPal's international expansion plans and could require PayPal to suspend providing services to customers in one or more countries.
Our auction business may be subject to regulation which could require us to modify our business practices.
Numerous states and foreign jurisdictions, including the State of California, where our headquarters are located, have regulations regarding how "auctions" may be conducted and the liability of "auctioneers" in conducting such auctions. No final legal determination has been made as to whether the California regulations apply to our business and little precedent exists in this area. Several states and some foreign jurisdictions have attempted, and may attempt in the future, to impose such regulations upon us or our users, which could harm our business. We are currently subject to potential regulation under the Office of Banks and Real Estate in Illinois concerning the applicability of the Illinois auction law to our services. In August 2002, Illinois amended its auction law to provide for a special regulatory regime for "Internet auction listing services." We expect to register as an Internet auction listing service in Illinois following the adoption of regulations under the amended statute. Although we do not expect this registration to have a negative impact on our business, other regulatory and licensure claims could result in costly litigation or could require us to change our manner of doing business in ways that increase our costs or reduce our revenues or force us to prohibit listings of certain items for some locations. We could also be subject to fines or other penalties. Any of these outcomes could harm our business.
We are subject to regulations relating to consumer privacy.
Several domestic jurisdictions have proposed, and California, Minnesota, Utah, and Vermont have recently passed, legislation that would limit the uses of personal user information gathered online or offline.
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Many jurisdictions already have such laws and continuously consider strengthening them, especially against online services. eBay and PayPal in certain instances are subject to some of these current laws. PayPal may be subject to recently enacted legislation in several states and countries imposing greater restrictions on the ability of financial services companies to share user information with third parties without affirmative user consent. However, the Fair Credit Reporting Act, or FCRA, a federal statute enacted in 1970 to protect consumer privacy, includes a provision preempting conflicting state laws on the sharing of information between corporate affiliates. The preemptive provisions of FCRA were permanently extended last year, thus ensuring that PayPal and eBay are not subject to the laws of each individual state with respect to matters within the scope of FCRA, but remain subject to the provisions of FCRA.
The U.S. Federal Trade Commission also has settled several proceedings against companies regarding the manner in which personal information is collected from users and provided to third parties. Specific statutes intended to protect user privacy have been passed in many non-U.S. jurisdictions, including virtually every non-U.S. jurisdiction in which we currently have a localized website. Compliance with these laws, given the tight integration of our systems across different countries and the need to move data to facilitate transactions amongst our users (e.g., to payment companies, shipping companies, etc.), is both necessary and difficult. Failure to comply could subject us to lawsuits, fines, criminal penalties, statutory damages, adverse publicity, and other losses that could harm our business. Changes to existing laws or the passage of new laws intended to address these issues could directly affect the way we do business or could create uncertainty on the Internet. This could reduce demand for our services, increase the cost of doing business as a result of litigation costs or increased service or delivery costs, or otherwise harm our business.
New and existing regulations could harm our business.
We are subject to the same foreign and domestic laws as other companies conducting business on and off the Internet. Today, there are still relatively few laws specifically directed towards online services. However, due to the increasing popularity and use of the Internet and online services, many laws relating to the Internet are being debated at all levels of government around the world and it is possible that such laws and regulations will be adopted. These laws and regulations could cover issues such as user privacy, freedom of expression, pricing, fraud, content and quality of products and services, taxation, advertising, intellectual property rights, and information security. Applicability to the Internet of existing laws governing issues such as property ownership, copyrights and other intellectual property issues, taxation, libel and defamation, obscenity, and personal privacy is uncertain. The vast majority of these laws were adopted prior to the advent of the Internet and related technologies and, as a result, do not contemplate or address the unique issues of the Internet and related technologies. Those laws that do reference the Internet, such as the U.S. Digital Millennium Copyright Act and the European Union's (E.U.) Directive on Distance Selling and Electronic Commerce have only recently begun to be interpreted by the courts and implemented by the E.U. Member States, so their applicability and scope remain somewhat uncertain. As our activities and the types of goods listed on our site expand, regulatory agencies may claim that we or our users are subject to licensure in their jurisdiction, either with respect to our services in general, or in order to allow the sale of certain items (e.g., real estate, event tickets, boats, automobiles).
In addition, because our services are accessible worldwide, and we facilitate sales of goods to users worldwide, foreign jurisdictions may claim that we are required to comply with their laws. For example, the Australian high court has ruled that a U.S. website in certain circumstances must comply with Australian laws regarding libel. As we have expanded and localized our international activities, we have become obligated to comply with the laws of the countries in which we operate. Laws regulating Internet companies outside of the U.S. may be less favorable than those in the U.S., giving greater rights to consumers, content owners, and users. Compliance may be more costly or may require us to change our business practices or restrict our service offerings relative to those in the U.S. Our failure to comply with foreign laws could subject us to penalties ranging from criminal fines to bans on our services.
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PayPal's financial success will remain highly sensitive to changes in the rate at which its customers fund payments using credit cards rather than bank account transfers or existing PayPal account balances. PayPal's profitability could be harmed if the rate at which customers fund using credit cards goes up.
PayPal pays significant transaction fees when senders fund payment transactions using credit cards, nominal fees when customers fund payment transactions by electronic transfer of funds from bank accounts, and no fees when customers fund payment transactions from an existing PayPal account balance. During 2003, senders funded 55% of PayPal's payment volume using credit cards. Senders may resist funding payments by electronic transfer from bank accounts because of the greater protection offered by credit cards, including the ability to dispute and reverse charges if merchandise is not delivered or is not as described, because of frequent flier miles or other incentives offered by credit cards, because of the ability to defer payment, or because of generalized fears regarding privacy or loss of control in providing bank account information to a third party.
PayPal has limited experience in managing and accounting accurately for large amounts of customer funds. PayPal's failure to manage these funds properly would harm its business.
PayPal's ability to manage and account accurately for customer funds requires a high level of internal controls. PayPal has neither an established operating history nor proven management experience in maintaining, over a long term, these internal controls. As PayPal's business continues to grow, it must strengthen its internal controls accordingly. PayPal's success requires significant public confidence in its ability to handle large and growing transaction volumes and amounts of customer funds. Any failure to maintain necessary controls or to manage accurately customer funds could diminish customer use of PayPal's product severely.
Our failure to manage growth could harm us.
We are currently expanding our headcount, facilities, and infrastructure in the U.S., internationally, and with PayPal. We anticipate that further expansion will be required to address potential growth in our customer base and number of listings and payment transactions, as well as our expansion into new geographic areas, types of goods, and alternative methods of sale. This expansion has placed, and we expect it will continue to place, a significant strain on our management, operational and financial resources. The areas that are put under strain by our growth include the following:
The Websites. We must constantly add new hardware, update software and add
new engineering personnel to accommodate the increased use of our and our
subsidiaries' websites and the new products and features we are regularly
introducing. This upgrade process is expensive, and the increased complexity
of our websites increases the cost of additional enhancements. If we are
unable to upgrade our technology, transaction processing systems, security
infrastructure, or network infrastructure to accommodate increased traffic
or transaction volume, our business could be harmed. Adverse consequences
could include unanticipated system disruptions, slower response times,
degradation in levels of customer support, impaired quality of users'
experiences of our services, impaired quality of services for third-party
application developers using our externally accessible Application
Programming Interface, or API, and delays in reporting accurate financial
information. Our failure to provide an increasing level of new features and
functionality in a cost-effective manner also could result in these
consequences. We may be unable to effectively upgrade and expand our systems
in a timely manner or to integrate smoothly with our existing systems any
newly developed or purchased technologies or businesses such as PayPal. We
are in the midst of significant multi-year projects to enhance our current
technical architecture. If these projects are not successful, our business
could be harmed. We have experienced periodic unscheduled downtime.
Continued unscheduled downtime would harm our business and also could anger
users of our websites and reduce future revenues.
Customer Support. We are expanding our customer support operations to
accommodate the increased number of users and transactions on our websites
and the increased level of trust and
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safety activity we provide worldwide. If we are unable to provide these
operations in a cost-effective manner, users of our websites may have
negative experiences, current and future revenues could suffer, and our
operating margins may decrease.
Customer Accounts. Our revenues depend on prompt and accurate billing
processes. We are in the midst of a significant project to enhance our
billing software. Failure to successfully complete this project or grow our
transaction-processing capabilities to accommodate the increasing number of
transactions that must be billed would harm our ability to collect revenue
and our business.
We must continue to hire, train, and manage new employees at a rapid rate. If our new hires perform poorly, if we are unsuccessful in hiring, training, managing, and integrating these new employees, or if we are not successful in retaining our existing employees, our business may be harmed. To manage the expected growth of our operations and personnel, we will need to improve our transaction processing, operational and financial systems, procedures, and controls. This is a special challenge as we acquire new operations with different systems. Our current and planned personnel, systems, procedures, and controls may not be adequate to support our future operations. The additional headcount and capital investments we are adding increase our cost base, which will make it more difficult for us to offset any future revenue shortfalls by expense reductions in the short term.
Our business is adversely affected by anything that causes our users to spend less time on their computers, including seasonal factors and national events.
Anything that diverts our users from their customary level of usage of our websites could adversely affect our business. We would therefore be adversely affected by geopolitical events such as war, the threat of war, or terrorist activity. Similarly, our results of operations historically have been seasonal because many of our users reduce their activities on our websites with the onset of good weather during the summer months, and on and around national holidays. We have historically experienced our strongest quarters of online growth in our first and fourth fiscal quarters. PayPal has shown similar seasonality, except that its strongest quarter of online growth has historically been the fourth fiscal quarter. We expect these patterns of seasonality to become more pronounced as our websites gain acceptance by a broader base of mainstream users and as the size of our European operations, which experience greater seasonality, grows relative to our other operations.
Our business may be harmed if our services are used for illegal purposes.
The law relating to the liability of providers of online services for the activities of their users on their service is currently unsettled in the United States and internationally. We are aware that certain goods, such as firearms, other weapons, adult material, tobacco products, alcohol, and other goods that may be subject to regulation, have been listed and traded on our service. We may be unable to prevent our users from selling unlawful goods or selling goods in an unlawful manner, and we may be subject to allegations of civil or criminal liability for unlawful activities carried out by users through our service. We have been subject to several lawsuits based upon such allegations. Our Korean subsidiary and one of its employees were recently found criminally liable for a listing on the Korean subsidiary's website. In order to reduce our exposure to this liability, we have prohibited the listing of certain items and increased the number of personnel reviewing questionable items. In the future, we may implement other protective measures that could require us to spend substantial resources or discontinue certain service offerings. Any costs incurred as a result of potential liability relating to the sale of unlawful goods or the unlawful sale of goods could harm our business. In addition, we have received significant and continuing media attention relating to the listing or sale of unlawful goods on our websites. This negative publicity could damage our reputation and diminish the value of our brand name. It also could make users reluctant to continue to use our services.
PayPal's payment system is also susceptible to potentially illegal or improper uses. These may include illegal online gambling, fraudulent sales of goods or services, illicit sales of prescription medications or controlled substances, piracy of software and other intellectual property, money laundering, bank fraud, child pornography trafficking, prohibited sales of alcoholic beverages or tobacco products, and online
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securities fraud. Despite measures PayPal has taken to detect and lessen the risk of this kind of conduct, illegal activities may be funded using PayPal.
PayPal is subject to money laundering laws and regulations that prohibit, among other things, its involvement in transferring the proceeds of criminal activities. Although PayPal has adopted a program to comply with these laws and regulations, any errors or failure to implement the program properly could lead to lawsuits, administrative action, and prosecution by the government. In July 2003, PayPal reached agreement with the U.S. Attorney for the Eastern District of Missouri that it would pay $10 million as a civil forfeiture to settle allegations that its provision of services to online gambling merchants violated provisions of the USA PATRIOT Act and further agreed to have its compliance program reviewed by an independent audit firm. PayPal is also subject to regulations that require it to report suspicious activities involving transactions of $2,000 or more and may be required to obtain and keep more detailed records on the senders and recipients in certain transfers of $3,000 or more. The interpretation of suspicious activities in this context is uncertain. Future regulations under the USA PATRIOT Act may require PayPal to revise the procedures it uses to verify the identity of its customers and to monitor more closely international transactions. These regulations could impose significant costs on PayPal and make it more difficult for new customers to join its network. PayPal could be required to learn more about its customers before opening an account, to obtain additional verification of international customers and to monitor its customers' activities more closely. These requirements, as well as any additional restrictions imposed by Visa, MasterCard, American Express and Discover, could raise PayPal's costs significantly and reduce the attractiveness of its product. Failure to comply with federal and state money laundering laws could result in significant criminal and civil lawsuits, penalties, and forfeiture of significant assets.
We are subject to intellectual property and other litigation.
In April 2001, our European subsidiaries, eBay GmbH and eBay International AG, were sued by Montres Rolex S.A. and certain of its affiliates in the regional court of Cologne, Germany. The suit subsequently was transferred to the regional court in Dusseldorf, Germany. Rolex alleged that our subsidiaries were infringing Rolex's trademarks as a result of users selling counterfeit Rolex watches through our German website. The suit also alleged unfair competition. Rolex sought an order forbidding the sale of Rolex-branded watches on the website as well as damages. In December 2002, a trial was held in the matter and the court ruled in favor of eBay on all causes of action. Rolex appealed the ruling to the Higher Regional Court of Dusseldorf and the appeal was heard on October 30, 2003. On February 26, 2004, the court rejected Rolex's appeal and ruled in our favor. If it so chooses, Rolex may appeal the ruling to the German Federal Supreme Court.
In September 2001, a complaint was filed by MercExchange LLC against us, our Half.com subsidiary and ReturnBuy, Inc. in the U.S. District Court for the Eastern District of Virginia (No. 2:01-CV-736) alleging infringement of three patents (relating to online auction technology, multiple database searching and electronic consignment systems) and seeking a permanent injunction and damages (including treble damages for willful infringement). In October 2002, the court granted in part our summary judgment motion, effectively invalidating the patent related to online auction technology and rendering it unenforceable. This ruling left only two patents in the case. Trial of the matter began on April 23, 2003. In May 2003, the jury returned a verdict finding that eBay had willfully infringed one and Half.com had willfully infringed both of the patents in the suit, awarding $35.0 million in compensatory damages. Both parties filed post-trial motions, and in August 2003, the court entered judgment for MercExchange in the amount of $29.5 million, plus pre-judgment interest and post-judgment interest in an amount to be determined. We have appealed the judgment and MercExchange has filed a cross-appeal. We continue to believe that the verdict against us in the trial was incorrect and intend to continue to defend ourselves vigorously. However, even if successful, our defense against this action will continue to be costly. In addition, as a precautionary measure, we have modified certain functionality of our websites and business practices in a manner which we believe makes them non-infringing. Nonetheless, if we are not successful in appealing the court's ruling, we might be forced to pay significant additional damages and licensing fees.
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In August 2002, Charles E. Hill & Associates, Inc. filed a lawsuit in the U.S. District Court for the Eastern District of Texas (No. 2:02-CV-186) alleging that we and 17 other companies, primarily large retailers, infringed three patents owned by Hill generally relating to electronic catalog systems and methods for transmitting and updating data at a remote computer. The suit seeks an injunction against continuing infringement, unspecified damages, including treble damages for willful infringement, and interest, costs, expenses, and fees. In January 2003, the case was transferred to the U.S. District Court for the Southern District of Indiana. After pending in Indiana for almost a year, the case was transferred back to the U.S. District Court for the Eastern District of Texas in December 2003. We are currently awaiting the judge's scheduling order in the case. We believe that we have meritorious defenses and intend to defend ourselves vigorously.
In February 2002, PayPal was sued in California state court (No. CV-805433) in a purported class action alleging that its restriction of customer accounts and failure to promptly unrestrict legitimate accounts violates California state consumer protection laws and is an unfair business practice and a breach of PayPal's User Agreement. This action was re-filed with a different named plaintiff in June 2002 (No. CV-808441), and a related action was also filed in the U.S. District Court for the Northern District of California in June 2002 (No. C-02-2777). In March 2002, PayPal was sued in the U.S. District Court for the Northern District of California (No. C-02-1227) in a purported class action alleging that its restrictions of customer accounts and failure to promptly unrestrict legitimate accounts violates federal and state consumer protection and unfair business practice laws. The federal court has denied PayPal's motion to compel individual arbitration as required by the PayPal User Agreement and has invalidated that provision of the User Agreement. PayPal has appealed that decision to the U.S. Court of Appeals for the Ninth Circuit. The two federal court actions have been consolidated into a single case, and the state court action has been stayed pending developments in the federal case. In September 2003, the plaintiffs filed their motion for class certification. In November 2003, the parties tentatively reached agreement as to the monetary terms for settlement of the disputes and we fully accrued for this tentative settlement amount in our income statement for the three months and year ended December 31, 2003. The parties have notified the court that they need time to negotiate and document other terms of any resulting agreement, and the class certification hearing has been rescheduled for March 29, 2004. If PayPal is unable to prevail in these lawsuits or settle them on acceptable terms, it may have to pay substantial damages and change its anti-fraud operations in a manner that will harm its business. Even if PayPal's defense is successful or if it is able to settle the lawsuits, the litigation could damage PayPal's reputation, require significant management time, and require changes to its customer service and operations that could increase its costs and decrease the effectiveness of its anti-fraud program.
Following the announcement of the PayPal merger in July 2002, three purported class action complaints were filed in the Delaware Court of Chancery by PayPal stockholders. The two California state court actions were consolidated and stayed. All of the complaints named as defendants PayPal and each member of its board of directors as well as eBay. The complaints were purported class actions that alleged that, among other things, eBay controlled PayPal prior to the execution of their merger agreement, the defendants breached fiduciary duties they assertedly owed to PayPal's stockholders in connection with PayPal entering into the merger agreement, and the exchange ratio in the merger was unfair and inadequate. The plaintiffs sought, among other things, an award of unspecified compensatory damages. In January 2004, the plaintiffs in the consolidated Delaware actions voluntarily dismissed these actions without prejudice. The consolidated California actions remain pending, but there has been no activity in them for over a year and the plaintiffs have indicated their intent to dismiss these actions.
In September 2002, Bank One Delaware (formerly known as First USA Bank, N.A.) filed a complaint against PayPal in the U.S. District Court for the District of Delaware (No. 02-CV-1462) alleging infringement of two First USA patents relating to assigning an alias to a credit card so as to eliminate the need for the physical presence of the card in a financial transaction. In September 2003, PayPal filed a complaint against Bank One Corp., Bank One Delaware's parent, in the same district court alleging infringement of a PayPal patent relating to a process that allows Internet users to make secure payments and authenticated transactions over a computer network. On October 20, 2003, the parties
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finalized the terms of an agreement to dismiss both lawsuits. The terms of the settlement agreement are confidential.
In November 2003, AT&T Corporation filed a lawsuit against eBay and PayPal in the U.S. District Court for the District of Delaware (No. 03-1051) alleging infringement of a patent entitled "Mediation of Transactions by a Communication System." AT&T claims that PayPal's and Billpoint's payment services infringe its patent, and seeks monetary damages and injunctive relief. On December 24, 2003, eBay and PayPal answered the complaint, denied infringement of AT&T's patent, and filed counterclaims. The case is at a very early stage, with trial currently scheduled for April 2005. We believe that we have meritorious defenses to this suit and intend to defend ourselves vigorously. Even if our defense is successful, the litigation could be costly and require significant management time.
In May 2002, Tumbleweed Communications Corporation filed a complaint against PayPal alleging infringement of two patents relating to electronic document delivery. Tumbleweed subsequently amended the complaint to add eBay as a defendant, and later amended the complaint to add a third related patent. On December 19, 2003, the parties entered into a settlement agreement dismissing the lawsuit, including counterclaims filed by PayPal, and entered into a patent cross-licensing agreement. The terms of the settlement are confidential.
Other third parties have from time to time claimed, and others may claim in the future, that we have infringed their intellectual property rights. We have been notified of several potential patent disputes, and expect that we will increasingly be subject to patent infringement claims as our services expand in scope and complexity. In particular, we expect to face additional patent infringement claims involving services we provide, including various aspects of our Payments business. We have in the past been forced to litigate such claims. We may also become more vulnerable to intellectual property claims as laws such as the Digital Millennium Copyright Act are interpreted by the courts and as we expand into jurisdictions where the underlying laws with respect to the potential liability of online intermediaries like ourselves is less favorable. We expect that we will increasingly be subject to copyright and trademark infringement claims as the geographical reach of our services expands. These claims, whether meritorious or not, could be time consuming, result in costly litigation, cause service upgrade delays, require expensive changes in our methods of doing business, or could require us to enter into costly royalty or licensing agreements.
From time to time, we are involved in other disputes that arise in the ordinary course of business. The number and significance of these disputes is increasing as our business expands and our company grows larger. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time, and result in the diversion of significant operational resources.
Government inquiries may lead to charges or penalties.
In January 1999, we received initial requests to produce certain records and information to the federal government relating to an investigation of possible illegal transactions in connection with our websites. We were informed that the inquiry includes an examination of our practices with respect to these transactions. We have continued to provide further information in connection with this ongoing inquiry. In order to protect the investigation, the court has ordered that no further public disclosures be made with respect to the matter. Should this or any other investigation lead to civil or criminal charges against us, we would likely be harmed by negative publicity, the cost of litigation, the diversion of management time, and any fines or penalties assessed.
A large number of transactions occur on our websites. We believe that government regulators have received a substantial number of consumer complaints about both eBay and PayPal, which, while small as a percentage of our total transactions, are large in aggregate numbers. As a result, we have from time to time been contacted by various foreign and domestic governmental regulatory agencies that have questions about our operations and the steps we take to protect our users from fraud. Both eBay and PayPal are likely to receive additional inquiries from regulatory agencies in the future, which may lead to action against either company. We have responded to all inquiries from regulatory agencies by describing our
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current and planned antifraud efforts, customer support procedures and operating procedures. If one or more of these agencies is not satisfied with our response to current or future inquiries, we could be subject to fines or other penalties, or forced to change our operating practices in ways that could harm our business.
We are subject to laws relating to the use and transfer of personally identifiable information about our users and their transfers, especially outside of the U.S. Violation of these laws, which in many cases apply not only to third-party transfers but also to transfers of information between ourselves and our subsidiaries, and between ourselves, our subsidiaries, and other parties with which we have commercial relations, could subject us to significant penalties and negative publicity and could adversely affect us.
Our business is subject to online commerce security risks.
To succeed, online commerce and communications must provide a secure transmission of confidential information over public networks. Our security measures may not prevent security breaches that could harm our business. Currently, a significant number of our users authorize us to bill their credit card accounts directly for all transaction fees charged by us. PayPal's users routinely provide credit card and other financial information. We rely on encryption and authentication technology licensed from third parties to provide the security and authentication technology to effect secure transmission of confidential information, including customer credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction data. A number of websites have reported breaches of their security. Any compromise of our security could harm our reputation and, therefore, our business. In addition, a party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations.
Our servers are also vulnerable to computer viruses, physical or electronic break-ins, and similar disruptions, and we have experienced "denial-of-service" type attacks on our system that have made all or portions of our websites unavailable for periods of time. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches. These issues are likely to become more difficult as we expand the number of places where we operate. Security breaches could damage our reputation and expose us to a risk of loss or litigation and possible liability. Our insurance policies carry low coverage limits, which may not be adequate to reimburse us for losses caused by security breaches.
In addition, our users, as well as those of other prominent Internet companies, have been and will continue to be targeted by parties using fraudulent emails to misappropriate passwords, credit card numbers, or other personal information. These emails appear to be legitimate emails sent by eBay or PayPal, but direct recipients to fake websites operated by the sender of the email or request that the recipient send a password or other confidential information via email. We actively pursue the parties responsible for these attempts at misappropriation and encourage our users to divulge sensitive information only after they have verified that they are on our legitimate websites, but we cannot entirely eliminate these types of activities. In addition to harming our users, these fraudulent emails may damage our reputation, reduce our ability to attract new users to our websites, and diminish the value of our brand names.
Our business may be harmed by the listing or sale by our users of pirated or counterfeit items.
We have received in the past, and we anticipate receiving in the future, communications alleging that certain items listed or sold through our service by our users infringe third-party copyrights, trademarks and tradenames, or other intellectual property rights. Although we have sought to work actively with the content community to eliminate infringing listings on our websites, some content owners have expressed the view that our efforts are insufficient. Content owners have been active in defending their rights against online companies, including eBay. Allegations of infringement of intellectual property rights have resulted in litigation against us from time to time. Such litigation is costly for us, could result in increased costs of
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doing business through adverse judgment or settlement, could require us to change our business practices in expensive ways, or could otherwise harm our business. Litigation against other online companies could result in interpretations of the law that could also require us to change our business practices or otherwise increase our costs.
We are subject to risks associated with information disseminated through our service.
The law relating to the liability of online services companies for information carried on or disseminated through their services is currently unsettled. Claims could be made against online services companies under both U.S. and foreign law for defamation, libel, invasion of privacy, negligence, copyright or trademark infringement, or other theories based on the nature and content of the materials disseminated through their services. Several private lawsuits seeking to impose liability upon us under a number of these theories have been brought against us. In addition, domestic and foreign legislation has been proposed that prohibits or imposes liability for the transmission over the Internet of certain types of information. Our service features a Feedback Forum, which includes information from users regarding other users. Although all such feedback is generated by users and not by us, claims of defamation or other injury have been made in the past and could be made in the future against us for content posted in the Feedback Forum. Claims like these are more likely and may have a higher probability of success in jurisdictions outside the U.S. where laws governing Internet transactions are unsettled. If we become liable for information provided by our users and carried on our service in any jurisdiction in which we operate, we could be directly harmed and we may be forced to implement new measures to reduce our exposure to this liability. This may require us to expend substantial resources or to discontinue certain service offerings, which would negatively affect our financial results. In addition, the increased attention focused upon liability issues as a result of these lawsuits and legislative proposals could harm our reputation or otherwise impact the growth of our business. Any costs incurred as a result of this potential liability could harm our business.
Customer complaints or negative publicity about our customer service could diminish use of our services adversely and, as a result, our business could suffer.
Customer complaints or negative publicity about our customer service could severely diminish consumer confidence in and use of our services. Breaches of our customers' privacy and our security measures could have the same effect. Measures we sometimes take to combat risks of fraud and breaches of privacy and security can damage relations with our customers. These measures heighten the need for prompt and accurate customer service to resolve irregularities and disputes. Effective customer service requires significant personnel expense, and this expense, if not managed properly, could impact our profitability significantly. Any inability by us to manage or train our customer service representatives properly could compromise our ability to handle customer complaints effectively. If we do not handle customer complaints effectively, our reputation may suffer and we may lose our customers' confidence.
Because it is providing a financial service and operating in a more regulated environment, PayPal, unlike eBay, must provide telephone as well as email customer service and must resolve certain customer contacts within shorter time frames. PayPal has received negative publicity with respect to its customer service and is the subject of purported class action lawsuits and state attorney general inquiries alleging, among other things, failure to resolve promptly certain account restrictions. If PayPal is unable to provide quality customer support operations in a cost-effective manner, its users may have negative experiences, PayPal may receive additional negative publicity and its ability to attract new customers may be damaged. Current and future revenues could suffer, or its operating margins may decrease. In addition, negative publicity about or experiences with PayPal's customer support could cause eBay's reputation to suffer or affect consumer confidence in eBay as a whole.
Acquisitions could result in operating difficulties, dilution and other harmful consequences.
We have acquired a number of businesses, including our acquisitions of Half.com, Internet Auction, iBazar, NeoCom, PayPal, CARad, EachNet, and FairMarket. We recently announced that we have agreed
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to acquire mobile.de, a German classified automobile-listing website, subject to receipt of regulatory approval. We expect to continue to evaluate and consider a wide array of potential strategic transactions, including business combinations, acquisitions and dispositions of businesses, technologies, services, products and other assets, including interests in our existing subsidiaries and joint ventures. At any given time we may be engaged in discussions or negotiations with respect to one or more of such transactions. Any of such transactions could be material to our financial condition and results of operations. There is no assurance that any such discussions or negotiations will result in the consummation of any transaction. The process of integrating any acquired business may create unforeseen operating difficulties and expenditures and is itself risky. The areas where we may face difficulties include:
diversion of management time, as well as a shift of focus from operating the
businesses to issues of integration and future products; declining employee morale and retention issues resulting from changes in compensation, reporting relationships, future prospects, or the direction of
the business; the need to integrate each company's accounting, management information,
human resource and other administrative systems to permit effective
management, and the lack of control if such integration is delayed or not
implemented;
the need to implement controls, procedures and policies appropriate for a
larger public company at companies that prior to acquisition had lacked such
controls, procedures and policies; and in some cases, the need to transition operations onto the existing eBay
platform.
Foreign acquisitions involve special risks, including those related to integration of operations across different cultures and languages, currency risks, and the particular economic, political, and regulatory risks associated with specific countries. Moreover, we may not realize the anticipated benefits of any or all of our acquisitions. As a result of future acquisitions or mergers, we might need to issue additional equity securities, spend our cash,or incur debt, contingent liabilities, or amortization expenses related to intangible assets, any of which could reduce our profitability and harm our business.
System failures could harm our business.
Any interruption in the availability of our websites will reduce our revenues and profits, and our future revenues and profits could be harmed if our users believe that our system is unreliable. Although our systems have been designed around industry-standard architectures to reduce downtime in the event of outages or catastrophic occurrences, they remain vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunication failures, terrorist attacks, computer viruses, computer denial-of-service attacks, and similar events. Some of our systems, including the PayPal site and PayPal's customer support operations, are not fully redundant, and our disaster recovery planning is not sufficient for all eventualities. PayPal, in particular, could be offline for a number of days in the event of a disaster in Northern California. Our systems are also subject to break-ins, sabotage, intentional acts of vandalism, and potential disruption if the operators of these facilities have financial difficulties. Despite any precautions we may take, the occurrence of a natural disaster, a decision by any of our third-party hosting providers to close a facility we use without adequate notice for financial or other reasons, or other unanticipated problems at our hosting facilities could result in lengthy interruptions in our services. In addition, the failure by our hosting facilities to provide our required data communications capacity could result in interruptions in our service. We do not carry business interruption insurance sufficient to compensate us for losses that may result from interruptions in our service as a result of system failures.
We have experienced system failures from time to time. eBay's primary website has been interrupted for periods of up to 22 hours. In addition to placing increased burdens on our engineering staff, these outages create a flood of user questions and complaints that need to be addressed by our customer support personnel. Any unscheduled interruption in our services results in an immediate loss of revenues that can be substantial and may cause some users to switch to our competitors. If we experience frequent or persistent system failures on our websites, our reputation and brand could be permanently harmed. We
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have been taking steps to increase the reliability and redundancy of our systems. These steps are expensive, reduce our margins, and may not be successful in reducing the frequency or duration of unscheduled downtime.
Our infrastructure could prove unable to handle a larger volume of customer transactions. Any failure to accommodate transaction growth could impair customer satisfaction, lead to a loss of customers, impair our ability to add customers, or increase our costs, all of which would harm our business.
Because our customers may use our products for critical transactions, any errors, defects, or other infrastructure problems could result in damage to our customers' businesses. These customers could seek significant compensation from us for their losses. Even if unsuccessful, this type of claim likely would be time consuming and costly for us to address.
Our stock price has been and may continue to be extremely volatile.
The trading price of our common stock has been and is likely to be extremely volatile. Our stock price could be subject to wide fluctuations in response to a variety of factors, including the following:
actual or anticipated variations in our quarterly operating results;
unscheduled system downtime;
additions or departures of key personnel;
announcements of technological innovations or new services by us or our
competitors; changes in or failure to meet financial estimates by securities analysts;
initiation of or developments in litigation affecting us;
conditions or trends in the Internet and online commerce industries;
changes in the market valuations of other Internet companies;
developments in regulation;
announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures, new products or capital commitments;
unanticipated economic or political events;
sales of our common stock or other securities in the open market; and
other events or factors, including these described in this "Risk Factors That May Affect Results of Operations and Financial Condition" section and
others that may be beyond our control.
In addition, the trading prices of Internet stocks in general, and ours in particular, have experienced extreme price and volume fluctuations in recent periods. These fluctuations often have been unrelated or disproportionate to the operating performance of these companies. The valuation of our stock remains extraordinarily high based on conventional valuation standards such as price-to-earnings and price-to-sales ratios. The trading price of our common stock has increased enormously from our initial public offering price and from our stock price during 2002. This trading price and valuation may not be sustained. Negative changes in the public's perception of the prospects of Internet or e-commerce or technology companies have in the past and may in the future depress our stock price regardless of our results. Other broad market and industry factors may decrease the market price of our common stock, regardless of our operating performance. Market fluctuations, as well as general political and economic conditions, such as recession or interest rate or currency rate fluctuations, also may decrease the market price of our common stock. Securities class-action litigation is often instituted following declines in the market price of a company's securities. Litigation of this type could result in substantial costs and a diversion of management's attention and resources.
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Problems with third parties who provide services to our users could harm us.
A number of parties provide services to our users that indirectly benefit us. Such services include seller tools that automate and manage listings, merchant tools that manage listings and interface with inventory management software, and other services. In many cases we have contractual agreements with these companies that give us a direct financial interest in their success, while in other cases we have none. In either circumstance, financial, regulatory, or other problems that prevent these companies from providing services to our users could reduce the number of listings on our websites or make completing transactions on our websites more difficult, and thereby harm our business. Any security breach at one of these companies could also affect our customers and harm our business. Although we generally have been able to renew or extend the terms of contractual arrangements with these third party service providers on acceptable terms, there can be no assurance that we will continue to be able to do so in the future.
Other companies or governmental agencies may view our behavior as anti-competitive.
Other companies have in the past and may in the future allege that actions taken by us violate the antitrust or competition laws of the U.S. or other countries, or otherwise constitute unfair competition. Such claims typically are very expensive to defend, involve negative publicity and diversion of management time and effort and could result in significant judgments against us, all of which would adversely affect us.
We have provided information to the Antitrust Division of the U.S. Department of Justice in connection with an inquiry into our conduct with respect to "auction aggregators" including our licensing program and a previously settled lawsuit against Bidder's Edge. Although the Antitrust Division has closed this inquiry, if the Department of Justice or any other antitrust agency were to open other investigations of our activities, we would likely be harmed by negative publicity, the costs of the action, possible private antitrust lawsuits, the diversion of management time and effort and penalties we might suffer if we ultimately were not to prevail.
We depend on the continued growth of online commerce.
The business of selling goods over the Internet, particularly through online trading, is dynamic and relatively new. Acceptance of and growth in use of the Internet as a medium for consumer commerce may not continue. Concerns about fraud, privacy, and other problems may discourage additional consumers from adopting the Internet as a medium of commerce. In particular, our websites require users to make publicly available personal information that some potential users may be unwilling to provide. These concerns may increase as additional publicity over privacy issues on eBay or generally over the Internet increase. Market acceptance for recently introduced services and products over the Internet is highly uncertain, and there are few proven services and products. In order to expand our user base, we must appeal to and acquire consumers who historically have used traditional means of commerce to purchase goods. If these consumers prove to be less active than our earlier users, and we are unable to gain efficiencies in our operating costs, including our cost of acquiring new customers, our business could be adversely impacted.
We depend on key personnel.
Our future performance depends substantially on the continued services of our senior management and other key personnel. Our future performance also will depend on our ability to retain and motivate our other officers and key personnel. The loss of the services of any of our executive officers or other key employees could harm our business. We do not have long-term employment agreements with any of our key personnel, we do not maintain any "key person" life insurance policies, and our Chief Executive Officer has fully vested the vast majority of her equity incentives. Our new businesses all depend on attracting and retaining key personnel. Our future success also will depend on our ability to attract, train, retain and motivate highly skilled technical, managerial, marketing and customer support personnel. Competition for these personnel is intense, and we may be unable to successfully attract, integrate or retain sufficiently qualified personnel. In making employment decisions, particularly in the Internet and
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high-technology industries, job candidates often consider the value of the stock options they are to receive in connection with their employment. Fluctuations in our stock price may make it more difficult to retain and motivate employees whose stock option strike prices are substantially above current market prices.
Our industry is intensely competitive.
We currently or potentially compete with a number of companies providing both particular categories of goods and broader ranges of goods. The Internet provides new, rapidly evolving and intensely competitive channels for the sale of all types of goods. We expect competition to intensify in the future. The barriers to entry into these channels are relatively low, and current offline and new competitors can easily launch online sites at a nominal cost using commercially available software or partnering with any one of a number of successful electronic commerce companies.
Our broad-based competitors include the vast majority of traditional department, warehouse, discount, and general merchandise stores, emerging online retailers, online classified services, and other shopping channels such as offline and online home shopping networks. These include most prominently: Wal-Mart, Kmart, Target, Sears, Macy's, JC Penney, Costco, Office Depot, Staples, OfficeMax, Sam's Club, Amazon.com, Buy.com, AOL.com, Yahoo! Shopping, MSN, QVC, and Home Shopping Network/ HSN.com. A number of companies have launched a variety of services that provide new channels for buyers to find and buy items from sellers of all sizes. For example, sites such as Buy.com, DealTime, Google's Froogle, MySimon.com, Nextag.com, and Yahoo! Product Search offer shopping search engines that allow consumers to search the Internet for specified products. Similarly, sellers are increasingly acquiring new customers by paying for search-related advertisements on search engine sites. We use product search engines and paid search advertising to channel users to our sites, but these services also have the potential to divert users to other online shopping destinations.
We also face competition from local, regional, and national specialty retailers and exchanges in each of our categories of products. Many competitors have been successful at establishing marketplaces that cater to a particular retail category, such as vehicles, tickets, or sporting goods. Additional category-specific competitors include:
Antiques and Art: Bonhams & Butterfields, Christie's, Sotheby's, Ruby Lane, Tias, Allposters.com, Artnet, Art.com, Barewalls.com, Guild.com, other regional auction houses, antique and art dealers and galleries, antique and collectible fairs, estate sales
Automotive (used cars and parts): Advance Auto Parts, AutoByTel.com, Autonation.com, AutoPartsPlace, AutoTrader.com, Autozone, Barons Ltd., Barrett-Jackson, California Classics, Car Parts Wholesale, Car-Part.com, CarMax, Cars.com, CarsDirect.com, Collectorcartraderonline.com, CSK Auto, Dealix, Discount Auto Parts, Dupont Registry, eClassics.com, ExpressAutoparts.com, General Parts (Carquest), Genuine/ NAPA, Hemmings, iMotors.com, JC Whitney, Kragen, Kruse International, OpenAuto.com, PartsAmerica.com, RM Auctions, Inc., TraderOnline, Trader Publishing, newspaper classifieds, used car dealers, swap meets, car clubs, vehicle recyclers
Books, Movies, Music: Abebooks.com, Amazon.com, Barnes & Noble, Barnesandnoble.com, Alibris.com, Blockbuster, BMG, Columbia House, Best Buy, CDNow, Express.com, Emusic.com, Tower Records/Tower Records.com
Business-to-Business: Ariba, BidFreight.com, Bid4Assets, BizBuyer.com, bLiquid.com, Buyer Zone, CloseOutNow.com, Commerce One, Concur Technologies, DoveBid, FreeMarkets, Iron Planet, labx.com, Oracle, Overstock.com, PurchasePro.com, RicardoBiz.com, Sabre, SurplusBin.com, Ventro, VerticalNet
Clothing and Accessories: Abercrombie.com, AE.com, Amazon.com, Bluefly.com, Coldwater-Creek.com, Delias.com, Dockers.com, Eddie Bauer, The Gap, Gap Online sites, J. Crew, JCrew.com, LandsEnd.com, The Limited, LLBean.com, Macy's, The Men's Wearhouse, Overstock.com, Payless.com, Ross, Urbanq.com, VictoriasSecret.com, Yoox.com
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Coins and Stamps: Collectors Universe, Heritage, US Mint, US Postal Service, Shop At Home, Bowers and Morena, auction houses, independent coin and stamp dealers
Collectibles: Collectiblestoday.com, Franklin Mint, Go Collect, Heritage, Mastronet, Replacements.com, Ruby Lane, Tias, antique and collectible dealers, antique and collectible fairs, flea markets and swap meets, specialty retailers, regional auction houses
Computers & Consumer Electronics: Amazon.com, Best Buy, Buy.com, Circuit City, CNET, CompUSA, Dell, Electronics Boutique, Fry's Electronics, Gamestop, Gateway, The Good Guys, Hewlett Packard, IBM, MicroWarehouse, PC Connection, PCMall.com, Radio Shack, Ritz Camera, Tech Depot, Tiger Direct, Tweeter Home Entertainment, uBid, Computer Discount Warehouse, computer, consumer electronics and photography retailers
Home & Garden: IKEA, Crate & Barrel, Home Depot, Williams-Sonoma Inc. (Pottery Barn, Williams-Sonoma), Bed, Bath & Beyond, Lowes, Linens 'n Things, Pier One, Ethan Allen, Frontgate, Burpee.com, Spiegel, TJ Max, Tuesday Morning, Kohl's
Jewelry: Bluenile.com, Diamond.com, Ice.com, Macy's, Mondera.com, HSN.com, QVC.com, Wal-Mart.com, Zales
Musical Instruments: Guitar Center/Musicians Friend, Sam Ash, Gbase.com, Harmony-Central.com, musical instrument retailers and manufacturers
Pottery & Glass: Just Glass, Pottery Auction, Go Collect, Pier 1 Imports, Williams-Sonoma, Replacements.com, Ruby Lane, Tias, antique and collectible dealers, antique and collectible fairs, flea markets and swap meets, specialty retailers, regional auction houses
Sporting Goods/Equipment: Amazon.com, Bass Pro Shops, Big 5, Cabela's, Dick's Sporting Goods, GSI Commerce, GolfClubExchange.com, Performance Bike, Play It Again Sports, REI, The Sports Authority, SportsLine.com, TGW.com
Sports Memorabilia: Beckett's, Collectors Universe, Gray Flannel, MastroNet, Lelands, NAXCOM, ThePit.com, Steiner Sports, Superior, hobby shops and discount retailers
Tickets and Experiences: Craigslist, Musictoday, Paciolan, RazorGator.com, SCI Ticketing, StubHub, Ticketmaster, Tickets.com, TicketsNow.com, ticket brokers
Tool/Equipment/Hardware: Home Depot, HomeBase, Amazon.com, Ace Hardware, OSH, Do-It-Best Hardware, True Value Hardware
Toys and Hobbies: Toys R Us, Amazon.com/Toysrus.com, KB Toys/ KBToys.com, FAO Inc. (FAO Schwarz, Zany Brainy, the Right Start)
Our international websites compete with similar online and offline channels in each of their vertical categories in most countries. In addition, they compete with general online e-commerce sites, such as Quelle and Otto in Germany, Yahoo-Kimo in Taiwan, Daum in South Korea, TaoBao and a proposed partnership between Sina.com and Yahoo! in China, and Amazon in the U.K. and other countries. In some of these countries, there are online sites that have much larger customer bases and greater brand recognition than we do, and in each of these countries there are competitors that have a better understanding of local culture and commerce than we do.
The principal competitive factors for eBay include the following:
ability to attract buyers and sellers;
volume of transactions and price and selection of goods;
customer service; and
brand recognition.
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With respect to our online competition, additional competitive factors include:
community cohesion and interaction;
system reliability;
reliability of delivery and payment;
website convenience and accessibility;
level of service fees; and
quality of search tools.
Some current and potential competitors have longer company operating histories, larger customer bases and greater brand recognition in other business and Internet sectors than we do. Some of these competitors also have significantly greater financial, marketing, technical and other resources. Other online trading services may be acquired by, receive investments from, or enter into other commercial relationships with larger, well-established and well-financed companies. As a result, some of our competitors with other revenue sources may be able to devote more resources to marketing and promotional campaigns, adopt more aggressive pricing policies and devote substantially more resources to website and systems development than we can. Some of our competitors have offered services for free and others may do this as well. We may be unable to compete successfully against current and future competitors. In addition, certain offline competitors may encourage manufacturers to limit or cease distribution of their products to dealers who sell through online channels such as eBay, or may attempt to use existing or future government regulation to prohibit or limit online commerce in certain categories of goods or services. The adoption by manufacturers or government authorities of policies or regulations discouraging the sales of goods or services over the Internet could force eBay users to stop selling certain products on our site. Increased competition or anti-Internet distribution policies or regulations may result in reduced operating margins, loss of market share and diminished value of our brand.
In order to respond to changes in the competitive environment, we may, from time to time, make pricing, service or marketing decisions or acquisitions that could harm our business. For example, we have implemented a buyer protection program that generally insures items up to a value of $200, with a $25 deductible, for users with a non-negative feedback rating at no cost to the user, and PayPal recently implemented a similar buyer protection program covering losses from selected eBay sellers up to $500, with no deductible. In addition, certain competitors may offer or continue to offer free shipping or other transaction related services, which could be impractical or inefficient for eBay users to match. New technologies may increase the competitive pressures by enabling our competitors to offer a lower cost service.
Although we have established Internet traffic arrangements with several large online services and search engine companies, these arrangements may not be renewed on commercially reasonable terms or these companies may decide to promote competitive services. Even if these arrangements are renewed, they may not result in increased usage of our service. In addition, companies that control user access to transactions through network access, Internet browsers, or search engines, could promote our competitors, channel current or potential users to their vertically integrated electronic commerce sites or their advertisers' sites, attempt to restrict our access, or charge us substantial fees for inclusion.
The market for PayPal's product is emerging, intensely competitive, and characterized by rapid technological change. PayPal competes with existing online and off-line payment methods, including, among others:
credit card merchant processors that offer their services to online merchants, including First Data, Paymentech, Wells Fargo, and iPayment; and
payment gateways, including CyberSource, VeriSign, and Authorize.net; Western Union Auction Payment at BidPay.com and Western Union MoneyZap.
Western Union is a subsidiary of First Data;
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Yahoo! PayDirect offered by Yahoo! and HSBC;
current and announced payment services offered by Amazon.com;
CheckFree;
processors that provide online merchants the ability to offer their
customers the option of paying for purchases from their bank account,
including Certegy and TeleCheck, a subsidiary of First Data; and
providers of traditional payment methods, particularly credit cards, checks,
money orders, and Automated Clearing House transactions.
Some of these competitors have longer operating histories, significantly greater financial, technical, marketing, customer service and other resources, greater name recognition, or a larger base of customers in affiliated businesses than PayPal. PayPal's competitors may respond to new or emerging technologies and changes in customer requirements faster and more effectively than PayPal. They may devote greater resources to the development, promotion, and sale of products and services than PayPal, and they may offer lower prices. Some of these competitors have offered, and may continue to offer, their services for free in order to gain market share, and PayPal may be forced to lower its prices in response. Competing services tied to established banks and other financial institutions may offer greater liquidity and engender greater consumer confidence in the safety and efficacy of their services than PayPal. If these competitors acquired significant market share, this could result in PayPal losing market share.
PayPal's service relies on the credit card networks, the Automated Clearing House network in the U.S., and similar bank clearing networks overseas. Associations of traditional financial institutions such as Visa, MasterCard and the National Automated Clearing House Association, or NACHA, generally set the features of these payment methods. Changes in these associations' rules could negatively affect PayPal's competitive position.
Overseas, PayPal faces competition from similar channels and payment methods in most countries and from regional and national online and offline competitors in each country including Visa's Visa Direct, MasterCard's MoneySend, ING's Way2Pay and Royal Bank of Scotland's World Pay in the European Community, NOCHEX, Moneybookers, and Royal Bank of Scotland's FastPay in the U.K., CertaPay and HyperWallet in Canada, Paymate in Australia and Inicis in South Korea. In addition, in certain countries, such as Germany, electronic funds transfer is a leading method of payment for both online and offline transactions. As in the U.S., established banks and other financial institutions that do not currently offer online payments could quickly and easily develop such a service. Effective July 1, 2003, financial institutions in the European Union are restricted from charging customers higher fees for many cross-border Euro payments than they charge for domestic Euro payments. This development could increase the effectiveness of using traditional financial institutions instead of PayPal for European customers seeking to complete cross-border payments.
Half.com competes directly with online and offline retailers in its product categories such as Amazon.com, as well as with traditional offline and online sellers of new and used books, videos and CDs, consumer electronics, and other products.
Our business depends on the development and maintenance of the Internet infrastructure.
The success of our service will depend largely on the development and maintenance of the Internet infrastructure. This includes maintenance of a reliable network backbone with the necessary speed, data capacity, and security, as well as timely development of complementary products, for providing reliable Internet access and services. The Internet has experienced, and is likely to continue to experience, significant growth in the numbers of users and amount of traffic. The Internet infrastructure may be unable to support such demands. In addition, the performance of the Internet may be harmed by increased number of users or bandwidth requirements or by "viruses," "worms," and similar programs. The backbone computers of the Internet have been the targets of such programs. The Internet has experienced a variety
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of outages and other delays as a result of damage to portions of its infrastructure, and it could face outages and delays in the future. These outages and delays could reduce the level of Internet usage as well as the level of traffic and the processing transactions on our service.
We must keep pace with rapid technological change to remain competitive.
Our competitive arena is characterized by rapidly changing technology, evolving industry standards, frequent new service and product introductions and enhancements, and changing customer demands. These characteristics are caused in part by the emerging and changing nature of the Internet. Our future success therefore will depend on our ability to adapt to rapidly changing technologies and evolving industry standards and to improve the performance, features, and reliability of our service. Our failure to adapt to such changes would harm our business. New technologies, such as the development of a peer-to-peer personal trading technology, could adversely affect us. In addition, the widespread adoption of new Internet, networking, or telecommunications technologies or other technological changes could require us to make substantial expenditures to modify or adapt our services or infrastructure.
We need to develop new services, features and functions in order to expand.
We plan to expand our operations by developing new or complementary services, products or transaction formats and expanding the breadth and depth of our pre-trade and post-trade services. We may be unable to expand our operations in a cost-effective or timely manner. We are pursuing strategic relationships with other companies to provide many of these services. As a result, we may be unable to control the quality of these services or address problems that arise. Expanding our operations in this manner also will require significant additional expenses and development, operations and other resources and will strain our management, financial and operational resources. The lack of acceptance of any new businesses or services could harm our business, damage our reputation, and diminish the value of our brand.
Our growth will depend on our ability to develop our brand.
We believe that our historical growth has been largely attributable to word of mouth. Both eBay and PayPal have benefited from frequent and high visibility media exposure both nationally and locally. We believe that continuing to strengthen our brand will be critical to achieving widespread acceptance of our services. Promoting and positioning our brand will depend largely on the success of our marketing efforts and our ability to provide high-quality services. In order to promote our brand, we will need to increase our marketing budget and otherwise increase our financial commitment to creating and maintaining brand loyalty among users. Brand promotion activities may not yield increased revenues, and even if they do, any increased revenues may not offset the expenses we incurred in building our brand. If we do attract new users to our services, they may not conduct transactions over our services on a regular basis. If we fail to promote and maintain our brand or incur substantial expenses in an unsuccessful attempt to promote and maintain our brand, our business would be harmed.
We may be unable to protect or enforce our own intellectual property rights adequately.
We regard the protection of our trademarks, copyrights, patents, domain names, trade dress and trade secrets as critical to our success. We aggressively protect our intellectual property rights by relying on a combination of trademark, copyright, patent, trade dress and trade secret laws, and through the domain name dispute resolution system. We also rely on contractual restrictions to protect our proprietary rights in products and services. We have entered into confidentiality and invention assignment agreements with our employees and contractors, and nondisclosure agreements with parties with whom we conduct business in order to limit access to and disclosure of our proprietary information. These contractual arrangements and the other steps we have taken to protect our intellectual property may not prevent misappropriation of our technology or deter independent development of similar technologies by others. We pursue the registration of our domain names, trademarks, and service marks in the U.S. and internationally. Effective trademark, copyright, patent, trade dress, trade secret, and domain name protection is very expensive to maintain and
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may require litigation. We must protect our trademarks, patents, and domain names in an increasing number of jurisdictions, a process that is expensive and may not be successful in every location. We have licensed in the past, and expect to license in the future, certain of our proprietary rights, such as trademarks or copyrighted material, to others. These licensees may take actions that diminish the value of our proprietary rights or harm our reputation.
We are subject to the risks of owning real property.
We own real property including land, buildings and interests in a partnership holding land and buildings, primarily related to our operations. We have little experience in managing real property. Ownership of this property subjects us to risks, including:
the possibility of environmental contamination and the costs associated with
fixing any environmental problems; adverse changes in the value of these properties, due to interest rate changes, changes in the neighborhoods in which the properties are located,
or other factors; the possible need for structural improvements in order to comply with
zoning, seismic, disability act, or other requirements; and possible disputes with tenants, neighboring owners, or others.
Some anti-takeover provisions may affect the price of our common stock.
Our Board of Directors has the authority to issue up to 10,000,000 shares of preferred stock and to determine the preferences, rights and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock may be harmed by the rights of the holders of any preferred stock that may be issued in the future. Some provisions of our certificate of incorporation and bylaws could have the effect of making it more difficult for a potential acquiror to acquire a majority of our outstanding voting stock. These include provisions that provide for a classified board of directors, prohibit stockholders from taking action by written consent and restrict the ability of stockholders to call special meetings. We are also subject to provisions of Delaware law that prohibit us from engaging in any business combination with any interested stockholder for a period of three years from the date the person became an interested stockholder, unless certain conditions are met. This restriction could have the effect of delaying or preventing a change of control.
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