The Travails of eBay Inc

Posted on 01/09/2010

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Formerly a market-darling, for the last 5 years, eBay’s stock price returned -40.5% lagging the S&P500 (-10.6%, excluding the impact of dividends) and also that of comparable Amazon (+206%).  But what has caused these disappointing shareholder returns, and is there any likelihood of an improvement?  Well, the shares have seen a valuation de-rating from a P/E 68x in 2005 to 12.6x today, so the question should instead be: “what are the factors that have made eBay investors so pessimistic about the future that they have de-rated the stoc k to such a lowly valuation?”

The Bear Case for eBay looks like this:

  • Competition is impacting the marketplaces business. eBay has undoubtedly been affected by competition, with Amazon taking market share in professional sellers, niche websites (eg Seatwave) gaining in specific categories and free services (eg Craigslist, Gumtree) impacting the bottom-end of the market. This led to the marketplaces revenue declining by 4.5% between 2007 and 2009.  So what has caused this? In the case of Amazon, they have offered a much more advanced service to professional sellers, which includes a fulfilment service to take care of all their logistics; with Seatwave and a plethora of niche marketplace websites, they can offer web technology much better-suited to the sale of
    The headquarters of eBay in San Jose, Californ...

    Image via Wikipedia

    their specific products, making the process easy/more profitable for sellers; and with respect to Craigslist/Gumtree, from the perspective of the irregular seller, why pay when you don’t have to? But it isn’t just strong competition that is impacting eBay’s marketplaces business – internet forums and message boards are awash with comments from angry eBay buyers and sellers, with concerns including: fraud; technical glitches; full-scale outages; high fees; problems getting refunds; poor customer service. Competition in online retail is clearly going to be around for good – entry into the market requires little capital; however, eBay’s existing strong position in the market, and the fact that many of the problems are internal (and therefore can be rectified) means that eBay does have the potential to undergo a turnaround. Whether this can be achieved depends largely on the management and their strategy.

  • Management are selling stock. One factor that is always a concern to investors is a management team with little confidence in the company they are managing, and nothing demonstrates this in quite the same way as directors offloading their personal holdings of stock. Gurufocus notes that since May 2010, five separate directors have sold a total of 421,663 shares of eBay stock (worth ~$9.8m at today’s price), with no directors making purchases.
  • Poor capital discipline. While eBay is highly cash generative (see bull case, below), management have run an inefficient balance sheet (no debt at present, despite its low cost), have bought back stock at the wrong times (a total of $2.7bn in 2007 and 2008 when the price went as high as $39.90, but none in 2009 when the share price fell as low to $10.43), have overpaid for acquisitions ($2.6bn for Skype in 2005), are hoarding cash on the balance sheet, and are paying no dividend. Given the poor record of management in this area, it is understandable that many investors do not trust them to suitably employ eBay’s capital. Their recent share sales also suggest that they have little confidence in their own ability to allocate capital or turnaround the marketplaces business.

The bull case for eBay is as follows:

  • eBay is significantly cash generative. In the last three years, the company has earned free cash flow (defined as cash from operations less fixed asset investments exc. acquisitions) averaging $2.2bn per annum. At the current enterprise value of $23.4bn (deducting cash of $4bn, short-term investments of $0.8bn and long-term investments – government & corporate bonds – of $1.8bn from the market capitalisation of $30bn) this equates to a free cash flow yield of 9.4%. At some point in the future, it is likely that this cash will be utilised, whether for acquisitions or shareholder distributions.
  • Strength of the PayPal business. PayPal has arguably become the payment method of choice on the internet, and has recently recorded revenue growth of 24%yoy and direct contribution at 50%yoy. While this growth will undoubtedly slow over time, PayPal is quite clearly on an attractive trajectory that will likely make the business much larger and more profitable in the future.
    eBay Analyst Day: John Donahoe

    Image by ebayink via Flickr

  • The marketplaces unit may have turned a corner. Ebay’s results for 1H10 show that the marketplaces unit recorded revenue growth of 12%yoy, and the accompanying management commentary indicates that this growth came from a variety of sources: “the inclusion of revenue generated from Gmarket, growth in sold items, higher take rate and continued growth at StubHub.” While this does include acquired growth from Gmarket, and could still be too early to form a trend, it is nevertheless encouraging that the division is now reporting revenue growth again.

  • On a sum-of-the-parts basis, eBay is worth much more than its current valuation. William Smead of Smead Capital Management, writing on Seeking Alpha, states his belief that eBay is worth around $36 per share, based on the following analysis:
    • Marketplace: At a 18 P/E = $22.48 (Includes StubHub, 28% of Craigslist, 5 of the 6 largest online classified businesses)
    • PayPal: At a 30 P/E = $ 9.60 (includes Bill Me Later)
    • Skype and Cash: $ 4.48
    • Total: $36.56

While Cautious Bull would argue with some of the numbers used in this analysis, he would support the underlying thrust of the argument that there is significant value within the business that is unappreciated by the markets at present and could potentially be unlocked via a break-up of the business into its constituent parts.

Overall, despite the concerns regarding the competitive position of the marketplaces segment and the potential for the misallocation of capital, I remain a bull on eBay stock.  I feel the strong balance sheet gives management the time they need to make the necessary changes to the marketplaces busines, and that they will make these changes (they’re not rocket science, after all).  With all the cash this company is generating, I expect that we will see more significant acquisitions and shareholder distributions in the near future.  Finally, there is little – if any – scope for the market to de-rate the shares, and significant potential for them to be re-rated.

Disclosure:  Cautiousbull is long eBay stock.

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