Dashed Upon the Rocks of eBay

OK, let's just get this out of the way. I geteBay (Nasdaq: EBAY  ) . I've understood and admired eBay for as long as I've known its existence. I've owned its shares before, I'd love to own them again.

In 2001, during some real market misery, when even mighty eBay had shed 70% of its value, I went on CNN and stated that I thought eBay would be valued at $100 billion by the end of the decade. It was valued at $11 billion then, the market prints it at $52 billion today. One more double in the next 5 1/2 years and eBay will have met my prediction. It may seem a bit odd to talk about a net gain of $48 billion as if it's fait accompli. It's not, because eBay could fail to gain another penny in market capitalization..

All of this gnashing of teeth is for a simple reason. Several years ago, I looked eBay up and down and declared the company to have the best business model in the history of mankind. This didn't stop me from selling the stock when I thought it had become overvalued. I did great on it -- but the shares have gained 200% since. There's just something that sticks in my craw about eBay, otherwise,there is every likelihood that I wouldn't have sold the stock.

My question, my deepest problem with eBay is this: Wy must the company dilute its shareholders so badly? Why is its compensation program so out of whack? We've talked about it before here at the Fool. Jeff Fischer, who, unlike me, continued to hold eBay stock, voted against a proposed increase in shares for stock options by 56 million in 2003, calling the company's compensation policies "excessive." At the time, eBay had a 12% overhang for unexercised shares that would dilute shareholders, and as the shares have done nothing but rise ever since, the vast majority of that 12%, plus the 4% of total share float issued in 2003, are all deep in the money. At current prices, that's about $7 billion in potential value.

That's expensive help
4% in options dilution each and every year is too much for any public company, much less one the size of eBay. In the first nine months of 2003, of the $0.47 per share the company reported, $0.22 were actually due to the fact that options expense for shareholders isn't reported on the income statement. That means that eBay, already extremely pricy per share, becomes insanely expensive when all costs to shareholders are taken into account.

But it's not the expense of eBay's shares that really bothers me. It's the decision to dilute shareholders this much when the company has absolutely no need to do so to remain an insanely great company. eBay has $2.7 billion in liquid assets on hand, including $1.3 billion in cash. I'm a proponent of equity ownership by employees, but the lengths that eBay goes to are unreal. I mean, yes, stock options may attract employees, but I doubt very seriously that eBay needs just this much honey to get people in the front door. By my estimation, this is the greatest business model ever devised. eBay has less business risk than any other company I've ever come across. It's a non-natural monopoly, the sui generis example of Metcalfe's Law, the awesome power of network effects. Yes, Yahoo (Nasdaq: YHOO  ) auctions has taken some wins, most notably in Japan. But eBay has less business risk than the vast majority of companies in the world. It could double prices tomorrow and still people would come back. Wal-Mart (NYSE: WMT  ) couldn't do this. Intel (Nasdaq: INTC  ) certainly couldn't. I don't even believe that Microsoft (NYSE: MSFT  ) could get away with it. But eBay can.

So, in a fit, last year I sold my shares in the company. And I've been tortured ever since.

Bad decision or bad break?
No, it has nothing to do with the rapid rise in price that's happened in the aftermath, because although it would have been a heck of a lot more fun being on the inside of that than on the outside looking in, I don't sweat bad outcomes for decisions well made. Particularly in the short term, the correlation between a good decision and a good financial outcome in the investment world falls well below 1.0. Sometimes people buy garbage companies, priced really, really high, and Lady Luck smiles upon them. Good choices and good outcomes are very, very different things.

What tortures me is the sneaking suspicion that I made a poor decision. Should my determination that eBay was horrendously expensive due to the hidden costs to shareholders should have been trumped by the fact that eBay simply is a company with unparalleled prospects? Is eBay the 6-sigma outlier, the company that can sport a price-to-earnings ratio exceeding 100, and deserve it? This is a company that has gone from a standing start in late 1995 to having just reported revenues exceeding $8 billion in the last three months. It's a company that has bought up two other well-positioned and highly profitable Web-based companies in Half.com and PayPal. (PayPal was a Motley Fool Stock Advisor selection, a position inherited by eBay after the companies merged.) And it's a company that no longer is completely dependent upon auctions -- more than 30% of its revenues come from fixed-price transactions.

Back in 1999, I managed to recognize eBay for what it was -- a market-leveler. People think of eBay in terms of selling Pez dispensers or comic books or the like, but even that early in its development, you could search for things like fertilizer or seeds or backhoes, and you'd recognize that eBay was taking the place of the old Sears (NYSE: S  ) catalog among some Web-savvy rural folks. It allowed them to tap sources for basic materials substantially more diverse than their local Southern states feed store. This became even more true after the dot-com meltdown, when eBay became the market of choice for companies to dispose of millions of dollars worth of routing and telecommunications equipment. In this regard, eBay simply has no equal, and minimal competition.

So, for want of a better compensation structure at eBay, I walked away from it as an investment. Frankly, I did so because I believed that the adjustments that I would make to net income made the company just too expensive to justify what was then an $18 billion market cap, even though I believed that it could be worth five times that in eight years. You don't buy companies based upon current results, though -- they're valued based upon the future, discounted back to today. eBay's future is almost guaranteed to be bright, which is good, because its stock price demands it. At some point the company's potential will not justify its share price. Just don't ask me when that will be, because I was convinced of this many, many billions in market cap ago. And now, I'm not so sure. The fact that I don't know tells me that I made an OK decision, but it's easy to be tortured by the overwhelming evidence that I was wrong.

Bill Mann was not the guy in the wedding dress. He has no position in any company mentioned in this article. The Motley Fool is investors writing for investors.


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