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Tuesday, July 27, 1999

An Investment Opinion
by Warren Gump

eBay's Amazing Profits

In today's column, I'm going to take a look at eBay's (Nasdaq: EBAY) earnings release. Those of you interested in the company simply because of the future potential of the Internet, the company's dramatic projected growth, and the infinite possibilities for this first-mover in Internet auctions need not read any further. I don't address those issues. At this point, I haven't developed the cognitive resources to even guesstimate what will happen in this market segment over the next few years.

What I can do, however, is utilize my ten-plus years of financial analysis to examine eBay's profitability last quarter. I do not have an ax to grind with the company -- I have never used the service and have no position in the stock. I picked eBay simply because it reported earnings yesterday and many sleight-of-hand tricks used by Corporate America can be seen in its press release.

You are probably well aware that investors no longer really look at the bottom line of a company -- instead of reported earnings, companies are leading analysts to consider earnings before acquisition charges, restructuring costs, amortization of intangibles, and amortization of "noncash" stock compensation. These exclusions are all expenses in the eyes of accountants, yet companies now sweep them under the rug in pro-forma reporting since they don't give a representative view of ongoing operations or a company's cash-generation capabilities.

The above-mentioned list doesn't incorporate regular stock option grants, since accountants and the Securities and Exchange Commission already allow them to be excluded from the reported income statement. The only thing that companies need report is the theoretical cost of this compensation expense in financial statement footnotes, so that they don't sully the actual income statement. I guess there isn't any reason to be alarmed over the fact that option grants are becoming an increasing portion of pay throughout our country. They're "noncash"... all the company is doing is diluting the ownership of existing shareholders.

According to yesterday's press release, eBay's "supplemental" Q2 earnings per share -- what it wants investors to focus on -- was $0.04, compared to $0.05 the previous year. With this number, eBay probably thought it had found the holy grail for an Internet company earnings report, with something to satisfy all constituencies. For those few people who are interested in plowing money into profitable companies, eBay can tout that it has a profit. On the other hand, eBay can remind those investors who believe it imperative to "invest for the future" that it was able to make less than it did in the prior year.

Those folks who deem it necessary for an Internet company to post losses might fear they've been left out in the cold. eBay didn't forget them, though. Their desire to see red ink can be satiated by focusing on operating results -- what eBay makes from actually conducting business. According to traditional income statement reporting procedures, the company had an operating loss of $4.6 million in the quarter. That number includes $4.7 million in merger costs and amortization of intangible assets.

Excluding those two expenses, which is a debatable proposition for a company growing through acquisitions, the company posted a whopping operating profit of $54,000. eBay also adds back noncash compensation amortization to its supplemental numbers, but I find it completely unreasonable to do so. Accounting requirements for stock options are so lax that any options expense required to be recorded on the income statement invariably should be. Of course, eBay doesn't mention its only nominal operating profit in the text of its press release.

Well, if the company had an operating profit of only $54,000 (again, that excludes acquisition and amortization expenses), how did the company post supplemental net income of $5.1 million? Chalk $1.5 million of the difference to the amortization of option expense. (Here's a little background to help you decide whether this should be an expense: At the end of 1998, eBay had granted options on more than 28 million shares at an average exercise price of less than $2 per share over the prior three years. The total cost of these options recorded as an expense on its income statement was less than $20 million. At current market prices, those options would be worth significantly more than $2.5 billion. Do you think that $1.5 million is too much to charge as an expense?)

The remaining $3.5 million difference between operating earnings and reported supplemental net income is tied to interest and other income. In other words, most of the reason eBay earned a profit this quarter is its deft use of the capital markets. The company raised $697 million in April from investors eager to pick up eBay shares at $170 apiece. By putting this money into cash and other investments, the company was able to boost net interest income to $6 million. After Uncle Sam took his 42% cut in taxes, eBay was left with an extra $3.5 million on its bottom line. As a result, most of the company's quarterly profit is tied not to success in the online auction business, but instead to its ability to raise cash from enthusiastic equity investors.

Many people likely view eBay's reported supplemental results with admiration. By taking advantage of accounting loopholes related to employee stock option grants and the willingness of analysts to ignore reported "one-time" and "noncash" expenses, the company is following in the footsteps of the most savvy American corporations that have been using similar tricks for years. Such moves help justify ever-increasing stock prices.

As more items accrue to the list of things that companies suggest should be excluded from costs when evaluating earnings per share, investors are increasingly relying on less-than-complete portraits of company operations. That may not matter in today's euphoric markets, but investors will likely take a more suspect view sometime down the road. As any experienced banker knows, ignoring traditional risks tends to be extremely profitable in a boom market, but proves devastating in a downturn.

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