Category Archives: eBay

Assessing eBay’s First Quarter

logoebay_x451eBay filed its first quarter 10-Q at the end of April, and the stock price launched. With two highly lucrative toll-booth businesses—brokered sales and payment services (Paypal)—and an exceedingly low price (briefly selling below $10 per share earlier this year), it caught our attention earlier this year. Though we haven’t found the recent decline in eBay’s GMV (gross merchandise value) concerning, we do continue to worry about eBay’s capital allocation, its managerial compensation, and its emphasis on favoring high volume sellers (see our previous analysis of pretended problems, potential problems, and rejoinders).

Regarding capital allocation, eBay repurchased no shares in the first quarter, despite seeing its lowest share price since early 2001. And true to habit, eBay entered a definitive agreement to acquire Gmarket Inc. after the first quarter closed, in April.   Over the years, eBay’s management has clearly preferred acquisitions to share repurchases, and not all of the acquisitions have been prudent uses of capital (see e.g., their recent sale of Stumbleupon back to its founders for less than their purchase price). Though it is possible that Gmarket at 27x trailing earnings is a better investment than eBay’s own shares at 13x trailing earnings, the former clearly anticipates robust growth that may not materialize. In my view, buying Gmarket rather than eBay’s own shares is the riskier route.

Our second worry has been eBay’s managerial compensation. Despite sub-par performance in their core marketplace business in recent years, compensation has decidedly increased. And the first quarter confirms the trend. Year over year, stock-based compensation expense grew from $87.4 million to $113.8 million, or a 30% increase. This in a quarter in which both net income and free cash flow were down significantly YOY. Though one should acknowledge that stock-based compensation expense can be lumpy and not consistently spread across all quarters, the first glance does not offer a pretty picture. We’ll be keeping watch in the quarters to come.

Our third and last lingering worry—that favoring high volume sellers may alienate too many sellers—is difficult to assess from quarter to quarter. Over at eBay Strategies, Scot Wingo has highlighted some of the recent changes in eBay’s marketplace business. Early indications show that buyers appreciate the reliability of eBay’s largest and favored sellers, and buyers consistently show their preferences for free shipping. Though management’s push for ‘free shipping’ strikes me as nothing more than silly irrationality (i.e., sellers will just increase list prices to compensate), the data so far seems to confirm management’s side.

All told, I must say that I was disappointed with eBay’s capital allocation and stock compensation expense for the quarter. Though their actions fit seamlessly with their past, I had hoped that a $10 share would have been too tempting not to bite. Given these three worries, the unexpected comprehensive income loss of $27.7 million for the quarter, the broad macroeconomic picture, and the recent 70% run-up in eBay’s share price, we have closed our position and will now watch from the sidelines.

Disclosure: No Position.

Hopping Happenings at eBay

logoebay_x45Rumors and news about eBay are popping onto the business newswire these days. Whatever they’re sizzling in their pan, it smells and looks like a new recipe. For a corporation with two excellent, high margin, wide moat businesses—auctions and Paypal—shareholders would welcome and do deserve a “dish” with better capital allocation in the years ahead.

So what’s the news? For one, Skype’s founders want to buy their creation back, though eBay denies that they’re close to a deal. Also, today, StumbleUpon’s founders disclosed that they had brought their baby back home, which they had sold to eBay for $75 million two years ago. And lastly, eBay appears close to purchasing a 34% stake in Korean online auction operator Gmarket.

One discerns the trend in these moves—increased concentration on auctions, retailing, and payment processing, and a decreased interest in Web 2.0 and 3.0 technologies. Originally eBay had expected more synergies with Skype, using VOIP as a new delivery channel for its auction and retailing site. But at their recent analyst day, eBay’s management acknowledged that such plans were unsuccessful. Going forward, eBay said it was content to cultivate and grow Skype into a great standalone business; of course, it now appears that they could be tempted to part, for the right price.

All this movement should make investment bankers salivate. Though we don’t yet know the final sale price for StumbleUpon, it is unlikely that eBay commanded much more than its purchase price. For Skype, rumors place a likely sale price at $2 billion; this for the business that garnered $2.6 billion from eBay four years ago.

The waste of time, talent, and resources on these two acquisitions is paradigmatic of eBay’s capital allocation over recent years. Though some cash has gone to repurchasing shares, more went to overpriced acquisitions—acquisitions for which there was no natural home in their fragmented bureaucracy. In the months ahead, shareholders should hope that this new recipe bears little resemblance to the old.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

eBay’s 2009 Analyst Day

logoebay_x451Today is eBay’s 2009 Analyst Day, and the meeting will be broadcast on the web starting at 8:00 AM PT. eBay is one of our significant current investments, and we have produced an extended series analyzing eBay’s economic moat and valuation. So we are eager to see what management will have to say for itself; the stock price has certainly been doing its share of speaking for some time now.

In anticipation of the meeting, eBay’s critics and observers have been pounding the web waves over the last week, offering their suggestions and speculating about future asset sales. Among the suggestions include selling the whole company to Microsoft or Google, selling Skype to Cisco, spinning off a portion of Paypal, and transforming the company into eBay 2.0. Trading at near 6x 2008 FCF, it strikes me that the former is most likely.

At any rate, we’ll be watching and eager to evaluate any proposed changes. Foremost in our minds are the strategic options for their cash held overseas, the possibility of creating an “eBay Local” site that concentrates solely on geographic distance (to snipe at Craigslist), and its progress on the current share buyback. Probably the best plan for current investors would be a coordinated debt offering and large stock tender offer. With no long-term debt and strong, cash flow businesses, they are not optimally levered in their current state. With today’s equity price, it seems a no-brainer to replace equity yielding over 15% FCF with debt costing 5-6%.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

Questions for eBay

logoebay_x45Yesterday, reader and fellow blogger Eboro and I chatted over email about eBay, one of my favored wide moat businesses and the subject of a extended blog series.  In my view, Eboro’s observations and questions reflect the current majority view about eBay and highlight important worries.  With permission, I have edited and posted some of the conversation here.

EBORO: “Recently, I started going over [eBay’s] annual reports as well as well as using various models (FCFE, Relative, Expectations) to value the business. Although this is an important part of my process, I spend even more time “scuttle-buttin” to discover what the users (buyers, sellers etc…) think about the company. Although I only started my examination a month ago, I’ve spent hours on the eBay forums reading over thoughts and comments, as well as asking questions. Out of interest, have you done this?”

WIDE MOAT: Yes, I’ve done this and have been impressed by the indiscriminate vitriol toward eBay.  In general, I’ve found seemingly impartial assessments criticized as dishonest and meritless.  Any critique becomes an invitation for a new chorus of boos.  This article at SeekingAlpha and the comments strike me as standard fare.  Or, see this WSJ blog post.  My impression is that there is a significant group of former sellers that are very upset with recent changes.  It’s almost as if they feel personally violated in some way.  Rather than quietly take their business elsewhere, they want others to know that they have been (morally?) wronged, and eBay’s management are fools.  Really, very odd…

EBORO: “I only ask because it was during this process that I realized something was not quite right at eBay: buyers and sellers were complaining, in huge numbers, about the business; literally thousands of sellers are leaving the site. It seems as though this could have a negative effect on one of the key elements of eBay’s moat: its network. In my opinion, eBay’s growth potential relies heavily on the following: buyers come to eBay because they know that there are an abundance of sellers; sellers come to eBay because they know there are an abundance of buyers. Buyers don’t find the selection they used to, they don’t find the low prices they used to, and eventually, they start leaving.  What happens when there is a reduction in the number and type of sellers? … What I’m focusing on is the future trend for users: is management suffering from “confirmation bias” or “overconfidence bias”, by blaming all their problems on the macro-economy, as opposed to their decisions? Have they tried to focus on elements that they have control over (such as user experience, fees etc.) to try and improve?”

WIDE MOAT: I agree with your observations.  Many sellers have left and are leaving.  Though I would note that new sellers are joining up as well.  If there were a significant and sustained reduction in the total number of buyers and sellers at eBay, I would be increasingly worried about its auction business, so that is something that I definitely want to watch closely.  Any data on this would welcome.

I know some sellers who did a lot of business with eBay and have left to sell from their own websites.  This is smart business decision and should be expected.  If sellers don’t need eBay to drive traffic and sales, then eBay won’t have much to offer.

I know other sellers who were upset by the fee increases.  Pricing is tricky.  When you are in the dominate market position, you want your fees to be as high as you can get them, without going too far.  There will always be cheaper alternatives–e.g., Craigslist, OnlineAuction.com, etc.  Those competitors have to offer something that eBay does not, and without traffic, they have to offer a lower price.  Again, this is something that I want to watch carefully.  If eBay drives off too many sellers with high prices, they will eventually have to cut fees to reverse the trend, and that is a time-consuming process.

My own view is that management is too brash and too insular, and their record of acquisitions is spotty.  In the end, I would like to see new management in place.  However, and I say this over and over–even while receiving repeated and dismissive scoffs–there are incentives in place for current management to change, or for them to be replaced.  If the stock continues to trade where it is, with options under water, and the company so cheap, eventually the numbers have to hit someone on the head.  The stock price is screaming that there are problems, and that, I’ve found, is typically one of the most effective generators of corporate change.  Now, I’m not saying that change is imminent, but I know of no other mechanism that consistently propels change like a low stock price.

EBORO: “On paper, eBay is indeed extremely cheap, and they indeed own a variety of businesses that have various moats in place. As you well know, however, having stellar management that is responsive to change is just as important as the moat. eBay’s management, in my opinion, does not posses the necessary qualities. It seems as though Omidiyar may have made a mistake in hiring Donahoe. Although his CV is indeed impressive, that does not mean that he has the temperament and character to run this type of business. In fact, he has no experience in the industry whatsoever: he spent years in the consulting business, which as you know, is great at getting huge fees but not as good at providing tangible results. The changes he has put into place have begun to have a serious negative effects on the core part of the business. He’s running the business like a consultant, and not like a business owner and user. They can blame the macro-economy if they so choose, but the question then becomes, why did Amazon (a somewhat similar business) have their strongest quarter to date in such a bad economic period?”

WIDE MOAT: His performance thusfar suggests that he cannot do the job well.  Blaming the macro economy is embarassing; a competent CEO focuses on things they can control, defines relevant metrics for evaluating success, and then does the job.  Currently Donahoe seems obsessed with “buyer safety” and making an eBay purchase as reliable as a Wal-mart purchase.  I haven’t see enough data to show me that this should be his primary concern, nor have I seen data showing that his changes have been successful.  So, I agree, Omidiyar may have made a mistake with Donahoe.

EBORO: “The reason, for me, is self evident: Bezos and Amazon focus on their customers and their customers wants/needs, as opposed to their competitors, and their competitors’ actions. As Bezos has pointed out: “we set our strategy around what we perceive are the big customer needs, and we know that what customers really want is stable over time. If you base your business strategy on things that are going to change, then you have to constantly change your strategy, whereas if you formulate your strategy around customer needs, those tend to be stable in time.” This is the type of CEO I want when I’m thinking of investing in a business…”

WIDE MOAT: At the risk of sounding like a cynic, I would first say that Bezos uses his golden tongue well.  And at some level, he’s right; you have to serve your customers’ needs to have any business at all.  But saying it so simplistically masks the complexities involved.  I suspect that what customers really would want are lower seller fees, better inventory, and better service.  These needs are costly for Amazon.  So the truth of the matter is that there always has to be a balance struck between buyers, sellers, Amazon’s shareholders, and management.  Signs suggest that they have struck a good balance with their current strategy, and the stock price reflects that.  It could always go higher, but I see more risk to the downside than potential gain to the upside.

EBORO: “This is not to say that examining your competitors is not important, but when you neglect the very people who make up the “network moat” that your business enjoys, you stand to seriously harm the fundamentals of your business. It seems as though eBay has been trying to imitate Amazon, at the expense of its customer’s needs. Their customers want low fees (fees have seriously increased as of late, final value fees on Buy it Now are 12-15% on top of monthly fees and listing fees, they also introduced a minimum listing fee), they want a reliable bidding system (anonymous bidding allows for people to organize “fake” bids to help increase the prices of their products), they want excellent customer support (you should read the eBay boards to see how people feel about this; it’s not good) they want reliable, cheap and fast shipping (eBay has set maximum fees and shipping costs) and they also want reliable and easy payment methods (eBay has removed money orders and checks etc… and leaves paypal as the only option, which has caused huge negative feedback from users).”

WIDE MOAT: To extend on my previous point, yes, customers want everything.  In my experience, eBay’s customer service happens almost wholly on the Paypal side.  As a buyer, I have had some instances of fraud on big ticket items, and I did have to make a phone call, but refunds were quickly forthcoming.  I like their dispute resolution mechanism, since it gives the buyer and seller a lot of time and opportunity to reconcile without eBay and Paypal getting involved.  In terms of Paypal’s resources, you do NOT want to be getting involved as Judge Judy in all of these little spats until it is absolutely necessary.  So, if people want eBay to immediately resolve everything in their favor, I see that as unsurprising, but relatively juvenile.

And there’s the rub.  In most “problem” transactions, one party is going to feel like they got a raw deal, so after every such transaction, you created someone who can potentially go on an Internet forum and complain.  With million of transactions, a lot of people will have reasons to be angry.  I’ve had some bad transactions there myself, but you try to resolve it, leave negative feedback, and live on; it’s the buyer or seller’s fault, not eBay’s.  I see eBay’s marketplace a little like the Wild West in that respect, and most buyers seem willing to accept that.  And like I’ve said, I’ve never had a problem getting a full refund with Paypal’s buyer protection policy, so the risks seem relatively low.

EBORO: “Amazon tried imitating eBay years ago, but this didn’t work, so they stopped (instead, they launched something similar, but different: their “third party retailer” business. This isn’t an auction type business, it’s simply a “used items” business. It’s working very well thus far). The point that I’m focusing on is the fact that Bezos truly understands his business, loves the business and it’s customers, and does everything in his power to be innovative and adaptable to demands – there’s a huge incentive for him to do so, as he owns 23% of the company. Donahue simply doesn’t seem to grasp this yet, and until he does, I can’t see myself buying into the company. I’d at least like to see him acknowledge this, and begin making the changes that will make users happy. This is the key part of this business, and buy catering to larger power sellers, at the expense of others, they may get larger sales for the huge volume sellers, but will lose the variety and diversity the smaller ones bring.

It’s interesting to note that the success of an investment is as much about the actual value of the business as it is about the speculative value of the business. Until others eventually agree with an analysis, the investment cannot be successful. It’s possible that many investors will continue to shy away from Ebay shares until their core business adapts to it’s customers and starts growing again. These, in my opinion, are the best bargains one can get: when management has already realized that changes need to be made, and are moving in this direction, and yet the market doesn’t price this in yet at all. A simple example of this would be Apple. The shares were a great buy at $15 in 2004, simply because you could see what Jobs was doing, and thought: he’s got it right, he’s bringing back the “style” that made Apple so successful to begin with, he’s got excellent products in the pipeline (that people clearly want), he provides a one of a kind “experience” with a very innovative platform (OSX) and he’s listened to customer wants/needs; and yet, the market isn’t pricing this in at all yet.”

WIDE MOAT: It strikes me that your last points are more about market timing.  And you may be absolutely right.  Perhaps pessimism surrounding eBay could increase.  Perhaps we’ll see evidence that management is changing its plan.  Perhaps then we’ll have the ideal opportunity to buy.  It definitely would be a better investment if new management were in place, with a smart plan, and the stock still trading at these levels.  I just don’t have the confidence that the stars will all align in this way.  Or, that I’ll be able to enter the stock at the most opportune time.

I like your assessment of what it takes for an investment to appreciate in price.  If you are buying a share of a business, rather than the whole business, then yes, you have to get other people to agree with your assessment of a business’ value in order to sell.  So when I buy, one strategy is to be a contrarian, and find a decent business inundated with pessimism.  Most of the time, of course, the pessimism is warranted, and the company’s problems intractable.  Here I don’t think that is the case.

The worst case scenario that I foresee is eBay continuing to lose GMV, beginning to lose users, seeing cash flows decline while expenses stay high, and the stock price continuing to fall.  Then the company gets taken out by Microsoft, or Yahoo, or someone else, at a lower price than I paid.  It is a risk, and it is possible.  It’s hard for me to imagine the stock price going much lower without someone buying the whole thing, but it could.  If I had 17 billion, I would have my unsolicited offer at their door by Monday morning.

Thanks for the questions, Eboro.  It’s been fun.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

eBay’s Margins and Moat

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.

eBay’s Potential Problems

So far, we’ve argued that auctions are a great businesslogoebay_x453, because they propel sales and do not require the auction house to hold inventory. eBay is far and away the leader in online auctions, with over 77.4 million unique visitors last month. eBay, in addition to its auction business, has a portfolio of growing businesses—some great profit generators (e.g., Paypal), others not so much (e.g., Shopping.com). And eBay is cheap, relative to its future earnings power, and relative to competitors.

Yet, eBay’s recent actions may portend potential problems. Contrary to other analysts and commentators, I do not find the decline in auction GMV concerning. However, three other problems do trouble me as a shareholder.

First, management has an potent desire for acquisitions. This desire has, along the way, led to some excellent uses of its free cash flow, but there has also been some serious duds. Their most recent large acquisition of Bill Me Later is interesting and will require some time to fairly evaluate. But given the current credit environment and consumer defaults, it does not strike me as a particularly opportune time to be entering this business. Looking forward though, with eBay priced at this level, it will be very difficult for management to find better uses of capital than to buy back its own stock. If management keeps up its acquisition spree with the stock at these levels, I will increasingly question the wisdom of their capital allocation.

Second, management is compensated very well. And perhaps excessively so. In 2007, stock-based compensation was 302 million, or about 14% of its 2.187 billion free cash flow. In 2008, stock-based compensation was 352 million, or about 15.2% of its 2.316 billion free cash. In short, compensation grew faster than cash flow; this is not a trend that an owner likes to see. Without getting too deeply into the details, an owner needs to keep a close eye on this trend.

Third, eBay’s recent emphasis on providing buyers with a ‘safer’ and ‘more reliable’ purchasing experience has pushed eBay to excessively favor its largest sellers in a potential buyer’s search results. Though the reasons for this move may be justifiable and good for the business, it does create a basic inequity among sellers that will alienate. This relatively new policy should be watched carefully, and management may need to adapt its strategy if the costs outweigh the expected benefits.

So there you have it. These are the real problems for eBay as a business. In my lights, prospective owners who buy at these prices are getting a bargain. But if these three problems continue to fester and grow, eBay’s intrinsic value may decline. And we would need to revisit our valuation.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

eBay’s “Problems”

The cacophony of eBay critics have been talking down the company’s value for over a year. The voices worry aloud about lower gross merchandise volume (GMV), lower auction revenue, and fewer eBay stores. I am not Pollyannaish; these are real concerns that portend real trends. But investors need to keep their eye on the ball. Will these concerns materially erode the business? What will be their likely effect on eBay’s free cash flow?

A few points. Critics often fixate on the worst number that they can find (often related to sales), rather than the most relevant (in my lights, free cash flow). For example, in the latest quarter (Q408), eBay’s marketplaces business unit (which excludes Paypal and Skype) recorded $1.27 billion in revenue, for a 16% YOY decline. Ah, woe, the sky is falling!

This is a big number, but two important caveats are essential for our analysis. First, a huge chunk of the drop in GMV (over a third) is a result of falling GMV for vehicles. Everyone knows that new auto sales are down nearly 50% YOY. Comparatively, eBay’s vehicle GMV was down 30%, or about $1 billion YOY. A second caveat—over half of eBay’s marketplace revenue is international. During the fourth quarter, the U.S. dollar increased significantly relative to most currencies. In their quarterly conference call, Bob Swan, eBay’s CFO, noted that excluding currencies and excluding autos, GMV in the core marketplace business was down 4%.

I would contend that a 4% decline in the core marketplace business, considered in itself, is not particularly significant for valuing the whole of eBay as a business. Active users at eBay increased 4% year over year. Active registered accounts at Paypal and Bill Me Later were up 23% YOY. The number of items sold were up 3% YOY. More customers bought more items, but at lower prices.

It is too soon then to conclude that eBay’s core marketplace business is in serial decline. Despite a terrible fourth quarter for retailers around the world, eBay’s annual free cash flow and earnings were up YOY. As the recession persists, and even if it deepens, eBay should weather the changes as well or better than its competitors in ecommerce. As we’ve seen, the 2008 numbers simply don’t show a significant problem in its marketplace business. But be assured, we’ll keep watching…

Coming up next—eBay’s “Problems,” Cont’d.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

Ebay’s Relative Value

logoebay_x452Many value investors scoff at the use of relative valuation techniques. At some basic level, the concept of intrinsic value resists any broader concern for prevailing market values. The sharp investor values only this business—relative to its assets or earnings power—and doesn’t worry about what Mr. Market thinks of it and its competitors. And historical stock market valuations would seem to confirm the intuitions of the saavy value investor. Just look at the NASDAQ bubble—what help would it have been to compare the value of a business to its insanely overpriced competitors?

However, recent research suggests that relative value arbitrage does provide market-beating returns. In addition, both Benjamin Graham and Warren Buffett used relative valuation at various points in their investing careers (though one should note that Buffett gave it up relatively quickly). In fact, in the 1960s, Buffett would borrow shares to short from the Treasurer of Columbia, and when asked which shares he wanted, Buffett said “just give me any of them.”

Most simply, the key to relative valuation, and long-short pair trading, is to find two businesses whose prospects are highly correlated. The standard example is Ford and General Motors. For two highly correlated businesses that are priced differently, the assumption is that business correlation will eventually filter into the businesses’ prices, and the arbitrageur can capture this spread.

For Ebay, many point to Amazon as its most correlated competitor. Both generate a substantial portion of their revenue from internet commerce, via the fixed-price sale of a wide array of consumer goods. As of today (2/12/09), Ebay trades at 7.4x its 2008 free cash flow, 1.55x book value, and 5.16x net tangible asset value. Amazon, on the other hand, trades at 20.15x its 2008 FCF, 10.27x book value, and 12.27x its net tangible asset value.

The best aspect about a paired trade is that it gives the investor multiple ways of being right—not only when Ebay’s value increases, but also when Amazon’s decreases. With multiple ways of being right, a value disparity is likely to fade more quickly. And more quickly realizing returns boosts a portfolio’s internal rate of return. It’s hard not to like that.

Coming up next—Ebay’s “Problems”

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.

Ebay as a Bond

Yesterday we valued Ebay as a profitable business that will produce moderately increasingly cash flows over time, by using a NPV analysis of those flows. However, as you may notice from the links on the sidebar, there are a fair number of bears out there who find Ebay’s business stagnant and the stock overvalued.

So, to assuage the worries of the most pessimistic investor, I propose that today we value Ebay as if the company itself were a bond and its future cash flows would consistently pay out at the same rate of 2008—that is, 2.32 billion.

Two decades of 2.32 billion “pay-outs” would return 46.322 billion. Of course, we wouldn’t be willing to pay 46 billion today for that amount to dribble back to us over twenty years. Keeping yesterday’s discount rate of 15% (our desired return), we should be willing to pay 14.497 billion today for those “pay-outs,” plus the current book value of the company (11.08 billion as of 12/31/08). In sum, $19.49 per share.

Let’s say you are still worried about your valuation of your Ebay “bond.” If you add a 25% margin of safety, that means you should be willing to buy the Ebay “bond” today for $14.62, providing even more cushion for your 15% expected return. Today, Ebay closed at $13.35.

To assume no growth for a premier company with a demonstrated love for acquisitions strikes me as unreasonable. Such an assumption also implies that Ebay’s cash flows will decline relative to population growth and inflation. Even if these highly unlikely scenarios came about, buying Ebay today should still generate an above average return on capital for a long-term investor.

Coming up next—Relative Valuation.

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.

Ebay–What’s it Worth? Part II

Yesterday we noted Seth Klarman’s three methods for valuing businesses and observed that a net present value logoebay_x45(NPV) analysis of future cash flows is most appropriate for a business with demonstrated earnings power.

With the help of Morningstar’s free cash flow data and the NPV function of Microsoft Excel, a NPV analysis is not a difficult exercise.

Since 2000, Ebay has grown its free cash flow from 50.4 million to 2.32 billion (2008). And from 2001-2008, Ebay grew its free cash flow at a 42% rate. These are simply phenomenal numbers—the result of starting from scratch and growing into a sector leader. More recently, the growth of Ebay’s free cash flow has slowed. In 2007, it grew about 23.2%, and in 2008, it grew about 5.6%.

As many know, in a NPV analysis of future cash flows, one must make a reasonable estimate of those future flows. Particularly in the case of Ebay, it is reasonable to expect those flows to be greater than today’s, given the company’s record of growing cash flows at a high rate. However, if one overestimates Ebay’s future growth, the NPV analysis will overvalue those flows. Thus, for those looking to buy a business’ future cash flows at a discount, it is very important to estimate future growth conservatively.

For today’s analysis, I will conservatively project that Ebay will grow its free cash flow at 10% over the next ten years, and then grow it at 5% for the following ten years. Given Ebay’s history of acquisitions, I expect 10% to be a reasonably conservative estimate for the next decade. 5% growth in my lights represents a business treading water—not gaining or losing market share—since 5% is a reasonable estimate of what the population growth plus the inflation rate will be for that decade.

Using these estimates, the net present value of the next two decades of Ebay’s cash flows, discounted at 15%, should be 27.6 billion. Add the 27.6 billion to Ebay’s book value, and you get a total value for Ebay of 38.68 billion. 

In other words, Ebay should throw off 119.94 billion in cash over the next two decades. However, we don’t want to pay that much solely to have it trickle back to us over twenty years; instead, we want a decent return on our capital outlay—say 15%. Thus, we should be willing to pay 38.68 billion today for 119.94 billion in cash outflows over the next two decades. Per share of Ebay, that amounts to a price of $29.47.

However, for any investment, one should only deploy cash when one has a substantial margin of safety. Estimates prove mistaken; management gets lazy; competitors spring up.  Given Ebay’s size and moat, a 25% margin of safety should be sufficient.

All told then, we should be willing to pay $22.10 per share for Ebay, expecting a 15% return on investment, with a 25% margin of safety. As of Friday, Feb. 6th, Ebay traded at $13.63 per share.

Coming up next—Valuation (even more conservatively), continued.

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.