eBay’s Bill Me Later

eBay’s 2013 10-k came out on Friday, and much there is worthy of comment.

For the last few years, I have followed the growth of Bill Me Later within the eBay portfolio, and over that time, my skepticism has increased commensurately (though perhaps ‘exponentially’ would be more accurate).

eBay acquired Bill Me Later in those interesting times of October 2008 for roughly $1 billion USD.

Basically, Bill Me Later offers promotional credit for eBay purchases.  From the 10-k:

“We also provide credit products through our Bill Me Later service. Currently, when a consumer funds a purchase using Bill Me Later, a chartered financial institution extends credit to the consumer, funds the extension of credit at the point of sale and advances funds to the merchant… Although the chartered financial institution continues to own each of the customer accounts, we subsequently purchase and retain most of the consumer receivables related to the consumer loans made by the chartered financial institution and are also responsible for servicing functions related to the customer account…  U.S. consumers may be offered an opportunity to defer payments under some promotional arrangements offered on select merchant sites. Interest on such purchases can be deferred for up to 18 months.”

In 2008, the receivables for Bill Me Later were more or less immaterial to eBay’s balance sheet.  In 2013, eBay purchased $794 million of consumer loan receivables, up modestly from the $727 million purchased in 2012.

In aggregate we find: “as of December 31, 2013, the total outstanding balance of [Bill Me Later’s] pool of consumer loans was $2.9 billion, of which the chartered financial institution owns a participation interest of $65 million, or 2.25% of the total outstanding balance of consumer receivables at that date.”

And apparently, I am not the only observer to have an eye on Bill Me Later, for:

“On August 7, 2013 and January 13, 2014, we received Civil Investigative Demands (CIDs) from the Consumer Financial Protection Bureau (CFPB) requesting that we provide testimony, produce documents and provide information relating primarily to the acquisition, management, and operation of the Bill Me Later business, including online credit products and services, advertising, loan origination, customer acquisition, servicing, debt collection, and complaints handling practices.  We are cooperating with the CFPB in connection with the CIDs.”

Disclosure: No Position

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Hopping Happenings at eBay

Rumors 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.

Morningstar’s Wide Moat Focus Index

As some may know, Morningstar currently has a Wide Moat Focus Index that “consists of the 20 securities in the Morningstar US Market Index with the highest ratios of fair value… to their stock price, and which have a sustainable competitive advantage…”

For those persuaded by the idea that some businesses have wider economic moats, but without the time or desire to go looking for them, the Index provides the investor with twenty places to start. As of 2/27/2009, the Index included Monsanto Company, Waters Corporation, Starbucks Corporation, Maxim Integrated Products, Fastenal Company, Zimmer Holdings, Applied Materials, Paychex, IMS Health, Forward Air Corporation, The Western Union Company, KLA-Tencor Corporation, Avon Products, eBay, International Speedway, St. Joe Corporation, Autodesk, American Express, Legg Mason, and Bank of America.

Even more useful is Morningstar’s description of their methodology for selecting the favored twenty. First, a business must pass the “show me the money” test, which demands that its return on invested capital (ROIC) has consistently exceeded its cost of capital. Having satisfied this initial screen, Morningstar analysts then assess whether the margin can be attributed to a clear competitive advantage. Morningstar classifies four major types of competitive advantage: high switching costs (e.g., Stryker), lower general costs (e.g., Wal-mart), valuable intangible assets (e.g., Harley-Davidson), or a sufficiently large network of users (e.g., eBay, NYSE).

Stryker benefits from high switching costs because surgeons that use their products would have a difficult time retraining their habits and skills to efficiently use a competitor’s. Wal-mart sells a wide array of basic consumer goods that could be purchased in numerous locations; that is, its products are practically indistinguishable—essentially commodities. In a commodity business, the only lasting advantage is being the perennial lowest cost producer, and in retailing that’s Wal-mart; in car insurance, Geico. Harley Davidson offers a product that its customers will pay a premium for (and then profess their undying love through abundant bodily art). eBay’s network of buyers and sellers offers each an optimal market experience; buyers find a rich selection, and sellers can solicit the largest number of buyers and presumably the highest prices.

Looking over Morningstar’s favored twenty, a couple businesses stand out. First, and perhaps with the benefit of hindsight, it is hard to imagine a retail bank like Bank of America with a sustainable economic moat. The little brick retail banks reign in ubiquity in our town, all seemingly offering similar rates and services. Though it may have been inconvenient to set up banking accounts in the past, online platforms have surely simplified the process.

American Express is also an interesting case. While swiping an AMEX used to carry some cache, today it is mere French vanilla. While American Express does have its credit card network, by sheer numbers, Visa’s and Mastercard’s stand superior.

All told, Morningstar’s Index highlights some interesting businesses for the wide moat investor. We’ll take a deeper look at some in the weeks ahead.

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

eBay’s 2009 Analyst Day

Today 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.

David Einhorn and Return on Equity

Here at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]

Buffett the Bondsman Revisited

Warren Buffett’s annual letter to shareholders arrived this past Saturday morning with the anticipated fanfare and has produced its usual industry of commentary. Ever since Berkshire’s 13-F became public (2/17/09), I have been thinking increasingly about whether current economic conditions should alter my investment strategy and return expectations. As we observed yesterday, Graham and Dodd seem to suggest that such changes are unnecessary, if our current holdings were acquired with reasonable expectations and a significant margin of safety. Yet, in Buffett’s letter, he discusses selling some equities (presumably purchased with the requisite margin of safety) in order to purchase fixed income securities:

“On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter &Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Of these three equities, I am most familiar with JNJ, a favorite of many value investors (including Prem Watsa and John Hussman). Joe Ponzio at F Wall Street has analyzed JNJ and given it an intrinsic value (using a discounted cash flow analysis) of $83.10. With future cash flows discounted at 15% and a 25% margin of safety, Ponzio would be willing to purchase JNJ below $62.33.

Though personally I find this valuation a bit high, it does show that JNJ has a significant likelihood of returning the investor at least 15% per annum. For Buffett to sell JNJ for his fixed income securities, I would contend that he either sees greater return potential in them, or a greater margin of safety for a similar rate of return. The conclusion then presses upon me—a 15% return in equities may not be sufficient in this market. If that’s true, then perhaps the appropriate strategic response is to increase the discount rate in my DCF evaluations, and/or increase my desired margin of safety.

Of course, we can still find wide moat businesses whose current prices look like bargains even with these heightened standards, but the list is shorter. Ebay makes the new list, but likely not the Washington Post Company.

Lastly, Buffett’s moves have inspired me to look further up the capital structure. In the past decade, corporate bonds rarely looked attractive relative to the projected returns for their equity. Now, however, one can find a few better risk-adjusted returns in the corporate bond market. Tomorrow we’ll look at one potential opportunity by comparing the equity of Sears Holdings with its outstanding bonds.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway, eBay, Fairfax Financial Holdings, and debt of Sears Holdings at the time of this writing.

Questions for eBay

Yesterday, 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.

Microsoft — What’s It Worth?

This past week, we spent some time assessing Microsoft’s moat. Though its Windows operating system and its Office suite are cheap to reproduce, easy to transfer and store, and require only a modest sales force, Warren Buffett acknowledged that a paradigm shift in communications could quickly undermine Microsoft’s position. Today Microsoft’s moat may be wide and deep, but consumer preferences may change rapidly in the next decade.

If Buffett is right, and consumer preferences could change in communications more quickly than their preferences in other areas (e.g., carbonated beverages, razors), then the prospective investor should be more conservative in her valuation of Microsoft, or perhaps, demand a greater margin of safety.

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.

Yet, even if Microsoft’s future is less certain than Coca Cola’s, what do we think the company is worth today? Following Seth Klarman’s recommendation, it makes good sense to value Microsoft by summing its book value with the net present value of its future cash flows. Many NPV analyses estimate a company’s earnings power over the course of the next two decades. But if we heed Buffett’s warning about a potential paradigm shift, perhaps we should dial back our estimates of future cash flows. Thus, in this valuation, we will only project Microsoft’s future cash flows over the next decade.

So let’s get to work. Using Morningstar’s data, we see that Microsoft generated 18.43 billion in free cash flow in 2008. Let’s conservatively project that Microsoft will grow its free cash flow at 5% over the next ten years (which may seem low, but which is rather close to their FCF growth over the past decade). Using these estimates, the net present value of the next decade of Microsoft’s cash flows, discounted at 15%, should be 115.6 billion. Add the 36.3 billion of Microsoft’s book value, and we get a total value of 151.9 billion. In other words, Microsoft should throw off 243.4 billion in cash over the next decade. But we wouldn’t pay that much solely to have it to trickle back to us over that decade; instead, we want a decent return on your capital outlay—say 15%. Thus, we should be willing to pay 151.9 billion today for 243.4 billion in cash outflows over the next decade. Per share of Microsoft, that amounts to a price of $17.08. With a 25% margin of safety, we should be willing to buy Microsoft today for $12.81—significantly below Friday’s closing price of $18.

Now, I can anticipate some of the objections to this meager valuation for what is today a market leader and cash cow. It is unlikely that Microsoft will have no earnings power after a decade; it is unlikely that a paradigm shift in communications will occur. It may be improbable that cash flows will only grow at 5%.

Leaving such objections aside for now, it is crucial that we highlight what looks to be the most important lesson in this analysis. If we cannot predict what a company will look like in twenty years, our valuation of it and its future earnings should be far lower than we typically expect. And here we see that for an investor like Warren Buffett, what looks today like a wide moat may not be sufficiently wide if we cannot reliably foresee its likely earnings in 2029.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway and 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 business, 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.