March 2, 1999
The Following Report Initially Appeared as the January 28th Rule Maker Portfolio Report
The eBay Model
By Tom Gardner ([email protected])
The beauty of eBay's business model is that it brings millions of people together to provide a service unavailable anywhere else. That may seem standard on the Internet, but it actually isn't. Most sites are providing services that offer little advantage over the traditional mediums of contact (TV, radio, magazine, etc.) and that capitalize very little on the unique characteristics of mass communication.
Think of it in horizontal and vertical terms. CBS Sportsline, a company that provides information, data and articles about the sports world, is a very vertical site. It generally hires a team of "sports experts" and expects its audience to come back every day to read their reports. Their model could actually exist as a daily newspaper -- a sports section -- with very little alteration from what they do now.
But eBay is quite the opposite -- featuring an extremely horizontal business model. They enable transactions and communication between millions of people. They essentially propose that individuals will get the best service out of a free-market environment... where status as an expert is earned, not bestowed. What is now happening is that eBay is providing a platform for hundreds of other businesses to reach buyers around the planet. Rather than being the one centralized business (as in the case of CBS Sportsline), eBay is giving its users access to a world of opportunities.
And, actually, that's the whole purpose of the Internet -- to provide worldwide value through decentralization. It's a new form of interaction and of business, not merely a distribution for new traditional-media-like companies to publish at their readers.
It's for that reason that eBay is a company with $47 million in sales and 140 employees, yet one that is now valued at more than $12 billion. That's amazing, but not that inefficient in my mind. It is being priced at more than 255 times its total sales, as the marketplace is saying, "My God, this is scalable. In just a few years, tens of millions of people accessing millions of businesses could be transacting minute by minute on this site." The same cannot yet be said of CBS Sportsline. Chances are, tens of millions of people are not going to come back every day to read articles by the same person. It just isn't expandable in the way that eBay is.
With that thinking as our guide, let's consider a few numbers. eBay has 2.1 million users today, up more than 70% just since September. The customer count is incredibly important to follow, and if you invested in this company, you'd want to break from your shares when you saw the growth rate of new customers slow down markedly. To post 72% customer growth over a three-month period is no slow down. It's quite likely that eBay will have more than 7 million registered users by the end of 1999.
On the sales front, eBay has grown from just $5.7 million last year to $47.3 million this year. That's more than 700% growth. At the same time, earnings have been on the rise as well. Now, you'll hear all the financial media blather on about the fact that Internet companies aren't making enough money to justify these valuations. Blah blah blah. Let's face it, two-year-old infants don't have full-time jobs either. Not making money is the natural process through which most great companies endure -- as they go from small bands of revolutionaries to prominent kings.
The question for investors is: Does the business model scale higher in such a way that tens of millions of people could be using the service over the next five years?
For eBay, I think the answer is yes. Though there's a lot of risk still out there. This horizontal model is certainly proving true for Yahoo! and Amazon.com. So far it has not proved true for C-Net, Sportsline, and many other more vertical sites. Still most investors (and nearly all of the financial media) are not yet drawing the distinction between the horizontal, scalable, network sites and the vertical, restrained, publishing sites (a category which The Fool sometimes falls too deeply into, though it's continually moving toward the horizontal, networking model I'm talking about).
If you have read this far, now I'm going to hit you with a few numbers. Probably you've stopped reading, though. If not, consider a few of the following ideas matched with numbers. First of all, eBay has a very attractive retailing model because it does not carry any inventory. That's the greatest risk for retailers -- the loads of unsold stuff sitting on shelves and in warehouses that costs money to carry while it loses money in value. A nightmare, the deathblow for many retail companies.
eBay doesn't carry inventory. Those who list stuff on the service for sale bear all the inventory carrying costs, and this is an enormous benefit for the company.
Second, consider that eBay is successfully building its business without needing to raise capital. Right now, the company has $31 million in cash and no long-term debt. It gets all the benefits of having savings locked away, earning interest, positioned for future investment. This is precisely the opposite of Donald Trump, with over $2 billion in debt at 13% interest. Ooof. Add to it the stagnation in customer growth, and you'll be very close to understanding why David is successfully short The Donald in the Rule Breaker Portfolio.
And finally, because eBay is nothing more than a series of software applications placed on servers, the actual cost of doing this business is extremely low -- certainly much, much lower than the cost of Amazon running its business. eBay does not buy products which it then must package and sell. Instead, eBay facilitates all of the material costs to its vendors. An amazingly wonderful business model; almost too good to be true.
The net result of this is gross margins above 85%. eBay has to invest in software programming, in server technology, and in customer service (a cost that is on the rise for them), but it doesn't have to have factories using parts to build widgets, which then must be assembled, packaged, and delivered. That 20th century "industrial business model" is an extremely expensive one. All those production lines cost a fortune. The opposite is playing out in the best spots on the Internet now. eBay is a fine example of that. It inverts the industrial model, as it simply enables the resale of stuff that was already made, or stuff that has been made by others, sold to others, through the eBay tollbooth.
That has a high-margin monopoly ring to it.
For this reason, if I were to invest in this company, I'd say to myself -- Heck, it may fall 50% at some point. In fact, I expect it to. But until I see the count of new customers slow down measurably, until I see its sales growth not dramatically on the rise, until either both or one of those things happens, I'm going to continue to hold the stock. I haven't invested in eBay. But I can understand why many have.