Description

eBay is a way better than average business currently being priced at an average market valuation. The reason for its relative undervaluation is two-fold: it is the classic left behind, less sexy piece of a spin off situation, and it compares unfavorably in terms of topline revenue growth rate to other large cap internet companies. Most notably, its closest large cap internet retail peer, Amazon, leaves it in the dust in terms of topline growth. But while Amazon has made some recent strides in the direction of operating profitability, its EBITDA margin has persistently been stuck in the low to mid single digits, whereas eBay’s has been in the 30s. This market has handsomely rewarded topline growth with a promise of profits far in the future – and the point of this piece is not to debate whether that makes sense or not – but it seems that since the recent split off of the eBay Marketplaces business from PayPal, most analysts have acknowledged that AMZN, at a growth at 3-4x the rate of EBAY is not the right comp for it, and have instead chosen to comp EBAY against traditional general merchandise retailers, now omnichannel but with a history of being store-based (retail chains like WMT and TGT). Against this comp set, as with AMZN, EBAY also compares well in terms of margin. But against this comp set – unlike with AMZN, EBAY actually compares well in terms of topline as well – performing at least in line if not better than the group. Equally important, the opportunities for EBAY to continue growing profitably going forward relative to the traditional retail comp set appear superior. But EBAY is valued at around the same valuation on an EV/EBITDA basis as the general retailers, despite having a higher organic growth rate, much higher operating margins, lower maintenance capex needs, and higher free cash flow. It’s a bit of a top down, relative value call, but I think this value relationship will eventually correct. It probably exists for a number of reasons including: 1) eBay standalone is a relatively new security (the split happened July 17, 2015), 2) eBay is covered on the sellside by internet analysts who are forced to have some neutrals and generally much more jazzed up recommending high growth names like Amazon and Facebook which have been working tremendously well for several quarters…if it was actually being covered by people who were also looking at WMT, TGT, HD, BBBY, or M – which is the comp set now that the sellside is using and the right comp set in terms of ballpark sales growth - they would probably rank this a relative buy, 3) people, in my opinion, are probably still too bullish on the likely comp trajectory of the traditional retailer comp set, which mean eBay’s future topline performance relative to its traditional retailer comp set may be currently being underestimated (i.e., traffic trends to traditional retail will continue to erode, hurting transactions and pressuring margins through real estate deleverage, persistent price transparency, and the loss of higher margin impulse purchases).

While it may be stating the obvious, it should be noted that the majority of eBay’s Marketplaces business is now fixed priced sales, as opposed to the original auction format, which they started out with in 1995.  In fact, about 80% of listings are now fixed price, and 80% of items sold are now new items. The auction business has long been in decline, essentially offsetting the growth of the fixed price business, which is analogous to the 3P (third party) business at Amazon where they do not do fulfillment, only list and take a commission for hosting and playing matchmaker on the transaction. eBay’s 2014 GMV of $83 bn represents about 10% of global ecommerce market (around $860 bn) but only around half a percent of global retail sales (over $16 trillion last year). Since online sales is growing faster than overall retail sales, EBAY will likely outgrow traditional brick and mortar retailers, even if its own growth fails to keep pace with the growth of online sales, i.e., it loses market share of online sales, which has been the case for several years, especially in the US, where it has lost share, primarily to Amazon, but also to the online divisions of brick and mortar retailers, most of which had been starting from smaller bases. That said, using the US as an example, where the ecommerce market has been generally growing mid teens and EBAY’s growth has often been more like half that, it has still grown extremely profitably (unlike many of its domestic online only competitors). It has also experienced an overall topline growth rate that still outpaced the consolidated topline of most large scale bricks and mortar retailers, where strong double digit online growth was often cannibalistic to brick and mortar same store sales which ranged from only slightly positive to flat to negative. As an online only player, even if the market share losses of recent history are to be extrapolated into the future, EBAY should still grow faster and more profitably than almost any traditional retailer because of the secular tailwind as commerce moves online.  

While there is no catalyst for overall multiple expansion relative to the retailer group or the market overall, there are a number of positive catalysts over the next several quarters that should help the market recognize that this is a business with a growth rate modestly above that of the average stock in the market, with operating margins materially and sustainably above the average stock in the market, using an asset-light model (therefore converting returns into cash), with below average business volatility and below market average valuation.  The two primary catalysts are easing comps and increasing cash returns. The reason for easing comps is that last year the company was affected by the Google Panda 4.0 Update to the SEO Algorithm, which hurt traffic in the back half of the year. Additionally, there was a data breach around the same time, which required 145 million users to change their password, an event that causes friction in the system (both from lack of trust/disinclination to use, as well as users then forgetting their new password). The rough second half of 2014 should help results accelerate over the course of 2015, although this is admittedly easy to figure out.

As for the cash returns, free cash flow guidance for 2015 was established at $2.1-2.3 bn (approx. 6.5% yield), 2016 free cash flow guidance was established $2.3-2.5 bn (approx. 7.0% yield), and a $3 bn stock buyback authorization is in place (approx. 9% of market cap). The company already bought back $1 bn in 1H2015 has a long history of buying back shares pre-split off, and also has about $1 bn in net cash on its balance sheet at the time of the spin (in addition to healthy cash generation). On top of buyback activities, the company has been active in shedding non-core assets. On the 2Q15 call, they announced the sale of their Enterprise division to private equity for $925 mm, they disposed of their stake in Craigslist, and sold $700 mm in BillMeLater receivables. The more non-core assets they shed, the better. It will be easier to see the core trends at Marketplaces, and they will have more money with which to buy back stock.

It is also worth noting that EBITDA margins – while still objectively high in the low 30s have been hit in the last year with a combination of one-time and cyclical pressures. In terms of one-times, the security breach had costs associated with it, and StubHub, eBay’s marketplace for after-market sales of tickets (scalped tickets) for sporting events, concerts, and other live events had a one-time reduction to take rates in 2014 due to competitive pressures. On the cyclical side, eBay does approximately 60% of its GMV (gross merchandise value) outside the US and that part of the business is growing faster (projected to be 70% by 2019), so FX has been a drag.

Valuation

As mentioned earlier, it’s impossible to comp EBAY to AMZN because it’s forever the ugly stepsister for being the share donator and slow grower, despite having generated billions in cash and profits while AMZN has generated barely any of either for its 3x growth rate. The top 4 US online retailers by traffic are Amazon, eBay, Wal-Mart, and Target…so if you aren’t going to compare #2 to #1, how about comparing #2 to #3 and #4?

EBAY is currently trading around 8.5x this year’s EBITDA and 7.5x next year’s EBITDA. FX-neutral GMV growth was guided 3-5% this year but with FX effects revenue is expected to be down about 1-2% this year and then up mid singles next year. GAAP EBITDA margins are around 32-33% this year expected to recover to mid 30%s next year. (The company also reports a higher Adjusted EBITDA margin with slightly less volatility but similar trends). As a point of reference, WMT is trading 8x this year and 7.9x next year’s EBITDA with revenue expected flat this year and up 3%ish next year. WMT is also suffering a little on the FX front, but its primary driver – US comps – are expected to be up only around a half a percent. EBITDA margins at WMT this year/next year should be within the recent historical range of 7-8%.  Looking at TGT, it’s trading at 8.5x 2015 and 8x 2016 for 2% topline and EBITDA margins in the 9-10% range. It just doesn’t make sense to me that EBAY should be trading inline with these other companies when its comps are modestly higher, its geographic diversification is exponentially greater, its capital intensity is way lighter, and its margins 3-4x as high. Perhaps this argues to a pair trade, but given the high margins, the below average cyclicality of this business (EBAY comped better than many retailers during 08/09), the cash generation/lack of capital intensity, I would argue this company deserves a decent premium to these other retailers, and would argue for a 25% premium or 10x multiple (which would still put it at a huge discount to its high growth, lower margin internet peers).  A 10x multiple on 2016 EBITDA of 3.7 bn would get you to $33, assuming  $2 bn in year end 2016 net cash ($1bn at time of separation), plus another 50c-$1 after taxes for their stake in MercadoLibre (MELI). That is a modest 18% up from here but I find it hard to find anything with compelling upside in this tape, plus I think the downside is relatively limited here as I don’t see a company of this quality – margins, lack of capital intensity, and overall size/market share/global reach/brand recognition - going below 7x EBITDA, and I don’t think forward estimates are particularly heroic.

Working backwards from $33, it implies a 16.5x multiple of $2ish of earnings in 2016. This does not seem like a very challenging valuation on a PE basis when you consider that mature retailers such as Wal-Mart, Target, Macy’s, and Staples trade between 15.5 and 17.5x 2016. Costco, Home Depot, and Lowe’s all trade over 20x 2016. Wal-Mart, Target, Costco, and Staples have single digit EBITDA margins, and Macy’s, Home Depot and Lowe’s are in the 12-15% range.  None of them with the possible exception of Costco are expected to grow their topline materially faster than EBAY.

I think this one could be a slow grinder for 10-20% per year through 5-10% topline, some margin recovery (from FX and StubHub) and modest incremental annual leverage, plus buybacks getting you there. Additionally, I think there a small possibility that now that the company is a more digestible size post the PayPal spin that it could conceivably become prey for M&A by someone looking to rapidly increase their presence in the US ecommerce market. Any global large cap retailer, ecommerce, or technology player could theoretically be on the buyer list in that scenario, although the two logical buyers would probably be Alibaba (BABA) – the largest global ecommerce player by both traffic and GMV, which has very little current presence in the US, or Wal-Mart, the largest US retailer of goods by a large margin, but it has recently seen its market cap eclipsed by AMZN and despite deep investments in ecommerce, remains a distant #3. In a takeout, EBAY would probably go for 12-15x, implying a valuation of $39-$49, using the same assumptions about 2016 EBITDA, net cash, and the value of MELI.

Risks

The biggest risk here, aside from a market crash or general macroeconomic/consumer spending risk, is just that this will be dead money. Fundamentals are stable here. Valuation is at the low end of the spectrum for an internet or technology company that isn’t in secular decline, but it isn’t screamingly cheap, just a little cheap – it is definitely more relative value than absolute deep value. There isn’t a reason to think business will fall apart, and it should accelerate quarter to quarter, given the easing comps, but there is no reason to expect it to explode either. In general, capital return or the smell of capital return is often enough to get a cheap-ish big tech stock moving (see the first leg of Apple when it started returning capital…and then it kept going to the moon on the product cycle, or also see the big move on GOOG’s 2Q earnings report, although it gave most of that back – so there is that risk).

The other main risk would be if GMV trends disappoint and require the company to invest more in marketing or tech than they have guided to, leading to margin pressure, and EBITDA estimates prove too aggressive.

Catalyst

Buybacks acclerate over 2H 2015 and into 2016.

GMV growth rates accelerate in 2H 2015 because of easy comps.

Additional non-core assets disposed of (StubHub? MELI?).

Over longer-term company gets better multiple for its superior business model/margins, lack of capital intensity, lower volatility relative to B&M retail

Over longer-term, will be secular beneficiary of secular traffic declines at brick & mortar stores/shift to online

Long shot possibility of being M&A target