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Thursday, November 12, 1998

An Investment Opinion
by Alex Schay

eBay's Rise

Here comes a familiar refrain: eBay (Nasdaq: EBAY) was bid up again today. The online auctioneer gained $10 1/16 to $126 on... no news. Yesterday, the restless stock dipped 11.4% after soaring 27% and 23% in the two prior trading sessions. In a case of "dueling brokers," eBay was downgraded to "market perform" by analyst Jamie Kiggen at Donaldson, Lufkin & Jenrette (DLJ) when the stock hit $130 -- by virtue of the fact that in DLJ's estimation eBay's equity has been "Over-Bought [in the] Near Term." Kiggen felt no compunction to raise his price target above $100 (based on a discounted cash flow and member-based model), which was established on October 26 when DLJ initiated coverage on eBay.

The day before DLJ cautioned investors to take a breather, Goldman Sachs raised eBay's target price to $150 from $90 (Tuesday), highlighting the notion that eBay "blends the best of the visibility and high margins of Yahoo's advertising model with the revenue momentum of's commerce model." According to Reuters, during the Goldman price target mambo, the firm also indicated that the numbers utilized were "conservative" and "likely to be raised in subsequent quarters." The important thing for investors to consider when investing in "hyper growth" Internet issues is that casting aside traditional metrics and buying at an analyst's target price essentially equates to signing off on all the assumptions inherent in the DCF model. Translation? In order to make a market return, just assume that all those solid operating quarters built into the numbers have already come to pass.

First, let's take a look at the business model that everyone is getting so excited about. On Labor Day in 1995 eBay opened for business, facilitating transactions between buyers and sellers of various goods on the Internet. It's important to realize that eBay just brings the participants together in a community forum and doesn't actually buy or sell items itself (unlike a broker/dealer on the Street). Hence, the company carries no inventory and makes 98% of its revenues through transaction costs to sellers -- the firm has yet to exploit traditional banner ads partly for fear of conflict with its community (though targeted category-specific partnerships are in the works). Here are the three tiers of transaction costs for sellers:

Insertion Fee -- $0.25 - $2.00
Feature Fee -- For promotion (optional)
Final Value Fee -- 1.25% - 5%

This model has resulted in eBay pulling down a very steady 6-7% in net revenues from gross merchandise sales. For example, in the last quarter over $195 million in goods were bid on at eBay, and the firm managed to bring $12.9 million to the topline in fee revenue. Given that 9.2 million auctions (about 100,000 a day) were hosted during the quarter and roughly half of those were actually completed, the average item auctioned went for about $40. This figure has risen 25% over the last ten months from $30. In terms of sheer transaction volume, eBay is facilitating an annualized $780 million worth of goods exchanged, which definitely puts it near the top in Web merchandise sales -- of course, it generates a minuscule annualized net margin of 0.0034% on gross mechandise sales.

Excluding non-cash charges for eBay's acquisition of Jump and $2.2 million for the amortization of stock compensation ($8.9 million over 4 years for "undervalued" stock sold to employees at the IPO, according to the SEC), operating margins at eBay in the third quarter held steady on a sequential basis at 21%. Gross margins dropped to 84% from 87.6%, thanks in part to infrastructure investments on the back end that will allow the company to operate at about 10 times its present online capacity. The economics of eBay's returns are impressive (consistent with the promise of all non-bricks-and-mortar Web operations), with a return on invested capital of about 46%. This figure nets out 95% of that huge lump of cash sitting on the balance sheet from invested capital -- where cash and equivalents actually represent 83% of total assets (thanks to the recent IPO).

What does eBay need to do to keep attracting new users and generate greater transaction volume? Well, in an attempt to consolidate its lead in the auction market, the company has to spend on advertising and promotion, although up until the fourth quarter of last year the company's growth was all through "WOM" -- word of mouth. In the third quarter the company spent $5.476 million on sales and marketing, and projecting that amount into the next quarter (with a slight increase) in order to compare it with the first six months means that the firm is spending roughly 2.5 times what it spent on marketing in the first six months. Estimating "product development" expenditures for the second half in a similar fashion yields a figure that is double what was spent in the first half.

What kind of growth is eBay getting from this projected investment? Well, registered users increased 48% from 851,000 in the second quarter, to 1,265,000 in the third quarter. Of course, with this kind of momentum it's impossible to figure out what can be attributed to the first six months of investment, but the growth is there. Consider that on October 20th eBay began a radio advertising campaign in 3500 spots. This comes on top of the firm's agreement with America Online at the beginning of August, the deals with 39 other Internet companies to direct traffic to eBay, and the ads in such magazines as Sports Illustrated, Time, People, and Newsweek. The firm is probably still working out which medium is generating the best return for its ad dollars, and this will continue to be a huge project for the balance of the year and beyond.

So what about competition? One of the biggest knocks against the firm is that it doesn't have any proprietary technology, and that "just about anyone" can get into the business. Today, there are really only two competitors worthy of note, the combination of Yahoo and OnSale at and Excite's Classifieds 2000 Both competitors offer free listings for users. In both instances, the firms' business models are natural extensions of their strategy to grow their base of users through the provision of unique services. It's important to note that both auction sites have been around for about a year -- in some incarnation -- and their existence hasn't put a damper on eBay's growth yet (although a renewed push on Yahoo's behalf is a threat).

Unlike, where the benefits of "community" can break down very rapidly when its prices are undercut by other online booksellers with similar delivery schedules, eBay's "community" offers a number of pretty concrete advantages. Thinking about what attracts participants to such a forum, two issues come to the fore: (1) the ability of sellers to get the maximum possible price for an item, and (2) the ability of buyers to find what they're looking for. Thus far, the fact that 30-40% of registered users are participating in auctions at any given time in a market with over 1000 unique categories of merchandise is pretty solid testimony to the network effects that have already played out at eBay. As far as buying merchandise goes, go to the site yourself and use the search function. Type in some relatively obscure collectors item that might be of interest to you -- you might be surprised at what you find. (This columnist has successfully bid on some old movie camera equipment and some out-of-print books.)

In addition to a critical mass that already commands attention, eBay's feedback system allows any user to make comments about any other user in order for each participant to build a business dossier of sorts. The ability to check the business transaction background of each user encourages everyone involved to conduct business in a professional manner, as well as allowing professional sellers to build a reputation (which is a big part of eBay's business). The bottom line is that existing users will not migrate elsewhere until they can get better prices and options elsewhere. Although on the buy side (joke intended) less liquid markets might provide prices that are lower than established markets -- opening the opportunity for arbitrage. "Deals" can still be found at eBay.

Of course, the analysis over the last couple of paragraphs has all been divorced from the question of what a buyer should reasonably pay for eBay's equity. Again, at current prices all the good things that are projected to happen -- like an 80% compound annual growth rate and operating leverage materializing -- have already been baked into the stock, and then some. This columnist's quick and dirty discounted cash flow puts a fair value on eBay at around $75 -- with a multiple on terminal value EBITDA that is probably lower than published estimates (at 10) and a discount rate of 20%. Taking published figures here and elsewhere, investors should build their own models and see what assumptions yield what results. While eBay may be an excellent business, it's certainly not trading at anywhere near an excellent price.