--Discover will equip its merchants to accept PayPal

--PayPal trying to transform from an online-payments company to a service for in-store purchases

--Analyst: Deal extends PayPal's lead in mobile-payments race

(Updates with analyst comments in paragraphs four and five, new share prices in paragraph six, details about the PayPal card in paragraph 10, analyst comment about Discover in paragraph 17 and details about PayPal's marketing plans in paragraphs 21 through 24.)

 
   By Andrew R. Johnson

PayPal is teaming with credit-card company Discover Financial Services (DFS) to expand use of the eBay Inc. (EBAY) subsidiary's nascent mobile-payments service from a few thousand merchant locations to potentially 7 million by the middle of next year.

The move could accelerate PayPal's efforts to transform itself from predominantly a tool for making online purchases to a viable option for making transactions in brick-and-mortar businesses, a market long dominated by traditional card-payment networks Visa Inc. (V), MasterCard Inc. (MA), American Express Co. (AXP) and Discover.

PayPal and Discover announced Wednesday the partnership, which will allow the credit-card company to equip its existing base of more than 7 million U.S. merchants to accept PayPal as a payment method, in addition to plastic cards, cash and checks.

The deal could catapult PayPal ahead of other competitors that are trying to take the lead in the race for mobile-payments dominance, said Gil Luria, an analyst with Wedbush Securities.

"All the other participants in the mobile-wallet race are still talking about thousands of locations, and PayPal is talking about getting to practically within a year 7 million locations," Mr. Luria said. "This appears to extend their lead quite significantly."

Shares of eBay were up 3.9% at $47.63 and Discover's shares were up 3.8% at $38.40 in recent trading. So far this year, eBay's shares are up around 57% and Discover's shares are up more than 60%.

PayPal, which boasts more than 50 million active U.S. customers, first began testing its in-store service early this year with Home Depot Inc. (HD), allowing customers to pay for purchases by entering a mobile phone number and PIN on the retailer's payment terminals rather than swiping a card or using cash.

Currently, PayPal has 16 national merchants signed on to its in-store service, including Home Depot, Abercrombie & Fitch Co. (ANF), Barnes & Noble Inc. (BKS) and Office Depot Inc. (ODP). The service is live in about 3,000 locations, according to spokesman Anuj Nayar.

PayPal also provides customers with physical cards they can use to perform transactions with merchants who aren't set up with a PIN pad and will continue to do so as part of its deal with Discover. Those transactions are still funded using a customer's PayPal account, which in turn can be funded using existing credit cards, debit cards and bank accounts.

PayPal customers won't have to request a card, Mr. Nayar said.

Under the new deal, Discover will use its existing relationships with merchant acquirers--the banks that help retailers process transactions--to set merchants up to accept PayPal. Merchants who sign on will pay processing fees to PayPal for any transaction made with the service, versus fees set by Visa, MasterCard and other payment networks for traditional card transactions.

PayPal has said its fees for in-store purchases are on a par with the card networks' rates.

Discover, which will process the transactions, expects that nearly all its merchants will be able to accept PayPal in the second quarter of next year, said Diane Offereins, president of payment services for the Riverwoods, Ill., company.

"Now we can do this at a scale that the consumer can adopt this and be able to use it every day in their life," Don Kingsborough, vice president of retail services for PayPal, said in an interview Tuesday.

Ms. Offereins declined to say how much additional transaction volume the deal could generate for Discover, which is the smallest of the four U.S. card networks based on volume. Discover's U.S. credit-card transactions totaled $63.24 billion during the first six months of 2012, according to the Nilson Report, a payments industry newsletter. By comparison, Visa's U.S. credit-card transactions totaled $490.24 billion, while $288.3 billion in transactions were made with American Express's U.S. credit cards and MasterCard handled $273.3 billion.

Still, Discover has worked to expand its acceptance footprint in recent years and is now a payment option with more than 95% of U.S. merchants, Ms. Offereins said.

The deal is a "big opportunity for Discover to get incremental revenue," Mr. Luria said.

Discover merchants will have the option of accepting PayPal, and those choosing to do so will be able to use existing point-of-sale devices for those transactions, Ms. Offereins said.

The partnership gives PayPal "a big leg up in terms of being able to sell their brand and be recognized as a legitimate service provider at the point of sale," said Rick Oglesby, a senior analyst with research firm Aite Group LLC. "You're greatly expanding the opportunity that consumers have to use" PayPal's in-store service.

However, PayPal is "going to have to do a lot of work in order to drive consumer adoption," Mr. Oglesby added.

PayPal will have to persuade customers to use their card versus existing cards in their wallets.

On a conference call Wednesday to discuss the deal, Mr. Kingsborough said PayPal already has a large base of existing customers, unlike other competitors who are pushing new "digital wallets."

"They have to go get people to put money in accounts," Mr. Kingsborough said.

PayPal will embark on a "full consumer program" to promote its new capabilities next year to customers, he added.

Discover's willingness to partner with PayPal highlights the divergent attitudes traditional payment companies have to partnering with up-and-coming players. PayPal is often viewed as a threat to credit-card networks because of its potential to siphon off transaction volume.

While PayPal users can fund transactions with existing credit and debit cards, they also can fund transactions using linked checking accounts and existing balances in their PayPal accounts, which potentially diverts transactions away from companies such as Visa and MasterCard.

PayPal says about half of the transactions made with its service are funded using credit and debit cards. Discover potentially risks diverting transactions that would be made with its own proprietary credit cards to PayPal, though it could recoup "what might be lost in direct fees from the merchants" by processing transactions for PayPal, said Beth Robertson, director of payments research with Javelin Strategy & Research.

PayPal and Discover are among a rapidly growing number of companies competing for dominance in the battle over consumers' "digital wallets."

World-wide mobile-payments transactions are expected to reach $171.5 billion this year, up from $105.9 billion in 2011, research firm Gartner Inc. said in May.

Visa, MasterCard and American Express are staking out their turf in the burgeoning mobile-payments market with so-called mobile wallets that can be funded with existing credit and debit cards.

Google Inc. (GOOG) made available a service last year that allows customers to make purchases by waving smartphones equipped with a technology called near-field communication in front of a payment terminal. Customers can fund Google Wallet with existing credit and debit cards from Visa, MasterCard, American Express and Discover, Google said earlier this month.

AT&T Inc. (T), T-Mobile USA and Verizon Wireless are also planning to test a competing service called Isis in Salt Lake City and Austin, Texas, this summer. Isis is intended to work with all four card brands as well.

Last week, more than a dozen retailers including Wal-Mart Stores Inc. (WMT), Target Corp. (TGT) and 7-Eleven Inc. announced the formation of a new company, Merchant Customer Exchange, that plans to develop yet another competing mobile-payments system.

Write to Andrew R. Johnson at andrew.r.johnson@dowjones.com

Subscribe to WSJ: http://online.wsj.com?mod=djnwires