PayPal's $2.2 billion acquisition of Swedish card terminal startup iZettle makes perfect sense - and Square should be worried

• PayPal is buying Swedish card reading startup iZettle for $2.2 billion.
• The deal looks expensive at 20x revenues and double iZettle's expected IPO valuation.
• But iZettle's in-store offering complements PayPal's online prowess and gives it a much more powerful sales pitch to take to businesses.
• PayPal plans to roll-out iZettle to new international markets and this will likely include the US - bad news for Square, which up until now has only really competed with iZettle in the UK.

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LONDON - PayPal surprised many industry observers with a $2.2 billion deal to buy eight-year-old Swedish card terminal company iZettle.

The deal is PayPal's biggest ever acquisition and comes less than two weeks after iZettle announced plans to go public. The Financial Times reported at the time that iZettle could seek a valuation of $1.1 billion in an IPO, suggesting a huge premium on PayPal's offer. The sale price is just over 20x iZettle's 2017 revenues and the company is loss making.

Mizuho Securities analyst Thomas McCrohan said in a note to clients on Friday: "We do not believe this was the acquisition shareholders were anticipating [and] the price paid appears expensive."

So why did PayPal think iZettle was worth it?

For PayPal, which was spun out of eBay in 2015, the deal makes perfect strategic sense. PayPal is traditionally more dominant in online and mobile payments, while iZettle produces card terminals that allow small businesses and sole traders to take affordable card payments. The deal means PayPal will suddenly gain an in-store presence in 11 new markets: Brazil, Denmark, Finland, France, Germany, Italy, Mexico, Netherlands, Norway, Spain, and Sweden.

As well as complimenting each other geographically, combining the two companies means the new group can offer what's known as an "omnichannel" solution to retailers.

As shopping increasingly moves online and mobile, traditional retailers want to be able to take payments through different channels: online, in-store, on mobile. By combining iZettle's terminal chops with PayPal's online know-how, the group can pitch itself as a one-stop-shop for merchants looking to solve all their payment problems. Management will hope that this new offering will supercharge revenue growth.

Once PayPal/iZettle is embedded in retailers, the company can then start to layer on additional revenue-generating services. iZettle has launched loans to customers based on the data gathered from terminal activity, for instance.

"While the 100% premium that they appear to have paid for iZettle may look high, it may prove to be a prudent call," Jonny Hunot, cofounder of UK iZettle rival The Good Till Company said on Friday.

"Mobile, cloud-based payment solutions are clearly the future gateway for billions of dollars of annual retail sales, and whoever owns these gateways stand to gain significant fees over the long term. This has always been the PayPal play."

Still, it's a gamble. McCrohan said in his note to clients on Friday that "acquiring iZettle does not alter how smaller merchants perceive PayPal as a tender type given the plethora of options already available for purchases in-store."

But the deal is at least a step in the right direction for PayPal. Crucially, it should also worry Jack Dorsey's Square.

Square and iZettle's products are very similar and both target the small business sectors. Up until now, they have only really competed head-to-head in the UK - Square is dominant in North America, while iZettle has a strong footprint in Europe and Latin America.

However, iZettle CEO Jacob de Geer said in a blog post on Friday that part of the logic of selling to PayPal was it would give the company a significant war chest to fuel international expansion. "We'll become iZettle with superpowers and jump on a fast track to realise our vision," he wrote.

The United States seems like an obvious market for iZettle to target. It's a huge market and also PayPal's core market.

Square, of course, has a big head start in the US, but iZettle's new firepower shouldn't be underestimated. PayPal's market capitalization is $96 billion, compared to Square's $21.7 billion, and PayPal will likely plan to invest in iZettle to reap the full expected rewards it wants from the takeover, especially if it's targeting long tail revenues that come from getting embedded within merchants.

Evercore advised PayPal on the deal, while JPMorgan were the sole financial advisors to iZettle.