eBay is the world’s largest online marketplace with close to $200bln of commerce volume in the last twelve months.  It’s well covered by the street and while most investors are familiar with the company, in our opinion, it still trades at a significant discount.  At 11.9x EV/2014 EBIT, with consistently strong ROIC, a very large total addressable market and defendable market share, eBay looks very attractive.  Additionally, the market seems to be missing the option value of PayPal offline and the transition to mobile.  Fortunately, due to management’s conservative short term outlook, announced during this week’s earnings, a cheap company became a little cheaper.

eBay is made up of three divisions:  Marketplaces, Payments and Enterprise.  The Marketplaces business seems to be growing quite steadily.  eBay is part of the larger tailwind of online ecommerce – where growth is slowing but still managing double digit rates worldwide. Gross Merchandise Volume (GMV) is growing steadily even though GMV of vehicles has declined sharply in the last 5 years. Non-vehicle GMV, however, has been growing at 12-13% for 2013. Marketplaces accounted for ~53% of revenues in 2012.

Over time, more of eBay’s business has shifted to fixed price versus auctions, with fixed priced accounting for 71% of transactions in the most recent quarter.  Because of this trend some observers are worried that eBay is moving directly into competition with Amazon.  This may be true but data suggests the market is more than large enough to accommodate both companies.  In order to compete with Amazon, eBay has taken action to simplify and lower the Marketplaces fees.  

There are several positive factors that may suggest that eBay’s business can be somewhat immune from competitive forces – namely because it was one of the first to build a large network of users.  New users feel that eBay is the most liquid marketplace for buying/selling goods, especially in the C2C segment.  For established users, who comprise very active sellers and pay the most fees to eBay, there are high switching costs.  For example, power sellers would have a difficult time replicating their reputation on another platform. To demonstrate how important a dominant position in the online marketplace business can be, look no further than eBay’s own attempt to enter the Japanese market, where Yahoo had an established position in auctions.  eBay was eventually forced to abandon its Japanese venture after frustratingly little progress.

The Payments division (Paypal) has grown substantially faster than the Marketplaces division.  Since 2004, Marketplaces revenues have increased 2.9x while Payments revenues have increased 8.0x, albeit from a much smaller base.  Growth in operating income has followed revenue growth for both divisions. The Payments division has historically had much lower operating income margins.  Paypal is currently exploring Paypal Offline as well as trying to establish itself as a strong competitor in the electronic wallet space.  Although it faces competition from large well capitalized competitors, if Paypal is even slightly successful, it could be a potentially large area of growth as the physical payments market is very large (estimated at $10 trillion or approximately ten times larger than the online market).  Although the sell side has picked up on the potential value of offline payments, there does not seem to be a good estimate for the potential value this can create to eBay shareholders.  However, we believe that at current prices we are receiving this option for free.

The Enterprise division specializes in creating, developing and running online shopping sites for brick and mortar brands and retailers.  It did $238mm of revenue in Q3 and $226mm in Q2, on merchandise sales of $787mm in Q3 and $698mm in Q2, so roughly $1bln in annual revenue.  Given its size and current growth it does not play a material part in our valuation.

Management has shown that it is focused on proper allocation of capital.  It tracks and reports ROIC on a quarterly basis with good transparency.  Additionally, in the Q3 presentation management bridges        cash on hand from quarter to quarter and demonstrates how it uses our cash.  Most recently, they spent $800mm on the acquisition of Braintree to help expand its presence in the mobile payments market.  On the Q3 conference call management noted that proceeds from the sales of certain equity stakes and a note receivable will help fund $485mm of the Braintree acquisition.

VALUATION

Historically, eBay has achieved very impressive returns on tangible invested capital well north of 20%.  Moreover, for the last 10 years eBay has been able to grow EBIT by 16% CAGR per year.  Net of cash, eBay trades at a P/E of 14.8x on our 2014 EPS estimates or 11.9x 2014 EBIT; cheap for a franchise of this quality.

We also valued the after tax cash with the following conservative assumptions:

• Discount rate of 10%.
• Terminal value (after year 5) is calculated using a growing perpetuity: 2% revenue growth rate for all 3 divisions, this along with the 10% discount rate implies a 12.5x multiple of forward year after tax cash flow for the terminal value.
• From 2008 to 2012, eBay after tax cash margin have been 24% on average (range: 18%-30%). Our model uses 18% after tax cash margins assuming some reduction in margins over time due to competitive forces as well as lower margins from the Payments division, as it becomes a larger source of earnings.
• We build out our initial 5 year growth rates using estimated US ecommerce growth for the marketplace division as estimated by Forrester Research. We forecast the payments division revenue growth to drop from the high-teens (Q3 2013 19% y/y) to mid-teens in year 5. Mid-single digit declining to low single digit revenue growth for the enterprise division. All division revenue growth rates are set to a very conservative 2% after the initial 5 year period.

Using these conservative assumptions we arrive at a price of ~$65 per share. Even though this price is 25% above where the stock currently trades, it does not take into account growth resulting from Mobile or PayPal Offline.  As an idea of how quickly Mobile is growing, it alone grew Total Payment Volume (TPV) from $4bln in 2011 to $14bln in 2012 and is projected to be at $20bln in 2013; in Q3 2013 mobile commerce volume was up 75% y/y. Similarly, if PayPal Offline is successful with its offline venture and can capture even a small slice of the very large offline market, then PayPal could grow even faster than it does already.