In our extended analysis of eBay, we explored some of the unique characteristics of the auction business. Our discussion highlighted qualitative factors that make auctions particularly profitable. But one could also do a more quantitative assessment of eBay’s profitability by looking more closely at its margins.
For example, using Morningstar’s data, we see that from 2003-2007 eBay averaged nearly 80% gross margin on sales and a 25% operating margin. eBay’s cost of goods sold is consistent and low, which makes sense, because the crucial component of the sales transaction that they provide—the website—is, most simply, computer code. They don’t need to worry much about raw goods prices, energy prices, or the cost of new production processes. Contrast the relative simplicity (and profitability) of eBay with General Motors. From 2003-2007 GM’s gross margins averaged about 15%, and their operating margins were a piddling 1%. With margins so low, a lot of things have to go smoothly for GM to turn a meager profit. And if business were quickly to turn, the company becomes vulnerable to bankruptcy.
On the other hand, a business with high margins has the flexibility to deepen and widen its moat. In fact, one might be so bold as to say that margins are the crucial determinant of a business’ moat. Even if a competitor were to challenge the business, high margins mean that a company could cut prices to compete, or redirect cash flows to better develop and market their product. For eBay, even if the cost of computer hardware, networks, or programmers escalates, there is substantial margin to absorb these added costs.
All told, we find eBay’s moat is wide and deep, and there may even be a crocodile or two in there. Qualitatively, the auction business is uniquely profitable; eBay leads in market share, and its brand is well known. And one can see these qualities expressed more tangibly in eBay’s consistent, high margins.
Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.
6 responses so far ↓
Jae Jun // February 19, 2009 at 5:14 pm
ebay’s greatest moat is its network effect. Sellers go to ebay because it’s where all the buyers are. The buyers go to ebay because it’s where the sellers are.
Cant compete with that.
widemoat // February 19, 2009 at 11:38 pm
I do think that the network effect is key. Yet, there are significant competitors with sufficiently large networks to compete. Some Ebay has bought–e.g., Half.com, Craigslist, Stubhub. Others stand apart–e.g., Amazon, Abebooks.
So I can see that some have replicated the network effect over time, and I suspect that others will in the future. There is a critical point beyond which the network effect feeds off itself; it is hard to achieve, but doable.
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[...] One thing is clear; Microsoft’s margins show that they offer a set of products that grant significant pricing power. Even after lumping all of their marginal products together with their cash cows Windows and Office, Microsoft has averaged over 80% gross margins on sales for the last five years (2004-2008), and a 34% operating margin over that same span. These margin numbers even best those of Ebay, one of our favorite wide moat companies. [...]
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Jeff Liang // March 9, 2009 at 7:10 pm
I would say that eBay has a wide moat when it comes down to selling used products over the Internet. It would be virtually impossible to create a competitive service from scratch because of the network effect.
However, eBay came into existence because of a new business model using a fast growing technology medium (the Internet). I think what investors need to be careful of is not whether someone can copy eBay, but rather if there will be a newer/better business model driven by newer technology. I think this is why Warren Buffett doesn’t invest in technology (besides a lack of understanding), it changes too quickly and is way too difficult to predict.
widemoat // March 9, 2009 at 7:49 pm
I agree, Jeff. eBay’s moat lies in its auctions and its network of buyers and sellers. I can imagine a competitor with a lot of buyers and sellers adding auctions, which would shrink the moat (e.g., Amazon, Craigslist), but I cannot see another auction site building up enough buyers and sellers to compete in the near future (e.g., etsy).
I do talk about Buffett’s reticence to buy technological moats here. Ultimately I don’t think it’s because he doesn’t understand them (even though this is what he says); rather I think it’s because he doesn’t believe anyone can accurately forecast their market position ten years from now.