At around 6x FCF, eBay offers an exceptional deal on two truly wonderful, tollbooth-style businesses – the eBay Marketplace and PayPal, each of which have a global brand and serve hundreds of millions of users around the world. From a financial perspective, these are gem-quality businesses that generate high-margin, highly recurring revenue streams that produce strong free cash flow on a quarterly basis with little seasonality. eBay has no inventory, no warehouses, and minimal fixed costs – or, in other words, none of the baggage that impacts many companies during a downturn.
One of Warren Buffett’s famous adages is that when a great business suffers a large but solvable problem, you can get a truly splendid investment opportunity. That’s essentially what we’re getting with eBay, whose stock is down more than 75% from its highs of $58 in late 2004. Over the past several years, eBay’s revenue and profits have continued to expand, albeit with a slowing rate of growth, particularly in the core auctions business which accounts for about 30% of overall revenue. The “large but solvable problem” is that eBay’s auction business has slowed to a virtual stand-still and the company’s growth efforts in the fixed-price arena are being hampered by intense competition from the likes of Amazon. Management is keenly aware of these issues and is actively seeking to make its marketplace business more appealing to both buyers and sellers. But even with slower growth and a more difficult competitive landscape, eBay is still a very strong and lucrative business: profit margins on a free cash flow basis are north of 25%; the balance sheet has significant excess cash of more than $3 billion; and, there remains excellent long-term growth potential, particularly within PayPal which comprises 27% of overall revenue and growing more than 20% annually.
Despite all the negative press aimed at eBay, it remains the world’s largest online marketplace with three times the merchandise volume of its nearest competitor (Amazon). eBay has more users, more traffic, and more successful transactions than any other e-commerce site. PayPal has perhaps an even more commanding position as the overwhelming leader in online payments, having warded off numerous competitors over the years. The most notable of these was the mid-2006 launch of Google Checkout, which tried to undercut PayPal’s pricing by 30%. It’s unclear how many users have adopted Google Checkout, but it seems telling that PayPal has experienced no slowdown whatsoever in users or payment volume over the past few years. Lastly, Skype is likewise the runaway leader in its segment of online voice and video communications. The #2 player, Jojah, advertises on its website that “10 million customers can’t be wrong” – but tell that to Skype’s 370 million customers.
In terms of economics, eBay functions essentially as a tollbooth on the e-commerce highway, where each of eBay’s key segments takes a cut of the transaction volume on its network. The eBay Marketplace, comprised of both the auction and fixed-price trading platforms, generates revenue of roughly $1.65 on every item listed with the number of listings now exceeding 700 million per quarter. Most of the marketplace revenue is now charged based on a cut of the final selling value (typically around 8% of the transaction value), such that eBay’s success is aligned with the success of its sellers. PayPal commands merchant fees of 2.9% of the transaction value (up to $3,000; above that, the fees decline to a low of 1.9% on transactions above $100,000) plus $0.30/transaction, with total payment volume on the PayPal network approaching $15 billion per quarter. Notably, PayPal’s take rate is even better than American Express’s average merchant fee of 2.05%, and much better than the 1.55% charged by Visa and MasterCard. Skype makes its service free for Skype-to-Skype calls, but charges on a per-minute basis for “Skype-out” calls to traditional phones with fees around $0.02/minute depending on the country. Lastly, eBay monetizes some of its marketplace website traffic via advertising.
Despite having such a dominant customer base (eBay and PayPal account for 95% of consumer-to-consumer online transactions in both the U.S. and Europe), eBay has faced numerous challenges in maintaining satisfaction amongst its community of marketplace buyers and sellers. Over the past few years, the eBay Marketplace has endured a series of fee changes that have steadily eroded customer satisfaction. First, in 2004, eBay cut its fixed-price store listing fees in an effort to encourage more fixed-price listings. Then, in 2006, after seeing how fixed-price listings were overtaking the core auction listings, eBay reversed course and raised its fixed-price listing fees (while reducing final value fees) in order to incentivize more auction-based listings. But this move caused overall listings growth to screech to a halt during 2007. This see-saw of pricing changes infuriated eBay sellers, while at the same time leaving buyers with a reduced selection of goods.
Thus on August 20, 2008, eBay announced that it would make it virtually free to place fixed-price inventory on eBay, where eBay’s fees would instead be sourced from a cut of the final value on successful sales. This was all in an effort to stimulate an expanded selection within eBay’s Marketplace, while aligning eBay’s financial success with that of its sellers. Although seller criticism of eBay remains quite vocal, it does appear that management is finally on the right track towards a set of policies and pricing guidelines that will create a healthier, more competitive marketplace.
eBay management is now addressing the most important problems in its marketplace business: fraud, bad sellers, clumsy website design, poor customer service, and excessive price increases. These are indeed problems – but solvable ones – and management is intently focused upon righting the ship. In early 2008, John Donahoe took the reins from longtime CEO Meg Whitman, and immediately set the following agenda: (1) make eBay safer and easier to use; and, (2) increase selection by blending auctions and fixed price in a “uniquely eBay way.” We’re still in the first year since these initiatives were launched, but already there are some promising signs that management is on the right track.
Regarding the safer/easier initiative, eBay has set into motion a number of changes. First, in Q1 ’08, eBay introduced incentives for sellers to deliver a higher-quality shopping experience to buyers. The mechanism here for change was eBay’s Detailed Seller Ratings (DSRs), which allow buyers to leave anonymous feedback that cannot be viewed by the seller in four areas: item as described, communication, shipping time, and shipping and handling charges. eBay has structured its search algorithms to drive more traffic to the high-DSR sellers, and thereby give buyers the best chance of having a high-quality shopping experience. In the two quarters since those changes were made, the number of sellers earning DSRs of 4.8 and above (out of 5.0) is up 20%, showing that eBay’s incentive structure has motivated sellers to improve in the key areas that lead to buyer satisfaction. Second, in Q2 ’08, eBay instituted unlimited protection for buyers and sellers on eBay.com when they use PayPal as their method of payment. Given that 60% of the Marketplace transaction volume is processed using PayPal, this means a majority of buyers and sellers are now enjoying a much safer shopping experience on eBay. These new protections for buyers and sellers also serve to demonstrate the power of eBay and PayPal operating together under the same corporate umbrella.
Regarding the selection initiative, eBay has reduced its upfront listing fees in order to spur an expanded selection of goods for sale – and the result has been a significant uptick in the formerly stagnant level of listings, which were up 26% YOY in Q3 ‘08 to 700 million items. Now, with listings growth back on the rise, eBay’s next important step is to optimize its search algorithms (an initiative it calls “Best Match”) in order to allow buyers to efficiently find the items for sale which offer the best quality of low price and high-quality seller. Beginning in Q1 ’08, eBay’s search algorithms began sorting results based in part on the seller’s DSR, thereby giving more exposure to higher-quality sellers. Of course, buyers aren't necessarily conscious that they're seeing higher-quality inventory, so it will take time for these changes to be seen in the results. eBay management has emphasized that Best Match is not a single monolithic rollout, but rather a series of iterations that eBay will continue to make based on the insights it derives from its proprietary data on closed transactions. The next area of focus for Best Match is layering in the company’s historical data on key search terms and improving the relevance of search results that come back.
It will take time to gauge the success or failure of these efforts, especially considering the backdrop of a rapidly weakening economy here at the end of 2008. But whether these initiatives succeed or other new changes are needed, I believe eBay management will eventually find a formula that allows for a healthy, growing business that delivers sizeable profits that can be returned to shareholders. Even amidst the current challenges, eBay retains strong competitive positions in e-commerce, online payments, and communications, each with a global brand and reach. The company serves hundreds of millions of users around the world and its proven business models generate solid revenue, healthy profits, and cash flow with minimum capital requirements. eBay is not saddled with inventory, warehouses or other fixed costs that frequently burden companies during an economic downturn. In sum, eBay is a business with the essential characteristics for above-average success over time.
At a recent price of $12.50, eBay has plummeted to levels not seen since the aftermath of the 9/11 terrorist attacks. eBay is currently valued at a market cap of $16.2 billion and EV of $12.4 billion (based on 9/30/08 balance sheet). Free cash flow in 2008 is expected to land somewhere between $2.1-2.3 billion, so the current EV/FCF multiple is around 6x, or P/FCF of around 7x. This means that if eBay were to merely maintain its current earnings power over time, with no growth whatsoever, investors could expect to achieve returns of 13-15% per year. This kind of cash-on-cash return is pretty remarkable for a business of eBay’s resiliency and reliability – a high-margin tollbooth style business that faces no customer concentration issues, no significant capex, and little seasonality to its FCF throughout the year.
The current valuation seems to imply the market believes eBay is either melting into obscurity or facing some kind of significant reduction in future earnings power. I believe such fears are wildly overdone. While it’s possible that the consumer recession underway may cause eBay’s revenue growth to stall in 2009, there remains clear growth potential looking out on a multi-year horizon due to the following factors: (1) Although e-commerce is no longer novel, it’s still steadily gaining share from brick-and-mortar retail, and this trend of ‘online switching’ will provide a secular tailwind for all of eBay’s businesses for many years to come; (2) PayPal is 27% of overall revenue and outgrowing eBay’s other segments, which means each year it’s becoming a larger portion of eBay’s overall business and thereby exerting an increasing influence upon the overall company’s growth rate. By way of example, consider that even if all of eBay’s other segments experienced flat revenue, PayPal’s 25% growth rate by itself would lead eBay to company-wide revenue growth of nearly 7%.
EBAY faces challenges, but it’s far from a broken model. The company faces solvable problems, and management is now intently focused on fixing the company’s problems. In addition, EBAY has the good fortune of tackling these challenges from a position of financial strength, including a solid position of excess cash and ongoing positive FCF. Investors will likely remain cautious for as long as EBAY is in the investment phase of righting its ship. Because a true turn in the fundamentals may be more than 12 months away, that largely explains the extraordinarily low valuation offered today of around 7x FCF. That said, if eBay’s business manages to hold up better in this recession than currently anticipated, the turn in the stock could happen sooner than expected.