Stock Advisor Buy List: eBay

At Motley Fool Stock Advisor we're about finding stocks with huge long-term upside. Our research efforts double-down on a company's growth potential, competitive advantage, and management quality. It's a strategy that has led to a total average return of 60% for our stocks and 14% annualized returns since inception versus 1% for the S&P 500.

Let's see why eBay (Nasdaq: EBAY  ) currently makes our buy list.

Growth potential
EBay's long-term growth potential lies solely on PayPal -- its fast-growing electronic payment processing business. In PayPal's early days, eBay was the growth engine while PayPal was simply an alternative payment method. A decade later, eBay's auction site is struggling to muster growth while PayPal has its foot firmly on the gas. PayPal provides secure online transactions for all kinds of purchases, and despite the recession, it has grown its top line 20% a year since 2007.

PayPal added 1 million new accounts each month during the second quarter. PayPal has moved beyond its eBay borders with about 60% of total payment volume coming from other merchants. Revenue for this off-eBay merchant business has grown 40% for three consecutive quarters. Much of the growth has come from abroad.

PayPal is growing 50% faster abroad than in the U.S., and more importantly, is spreading its brand in a huge market. The largest growth opportunity lies in Asia where the most developed online retail markets are Japan and South Korea. PayPal recently landed a deal with Softbank in Japan, gaining access to a $25 billion e-commerce market and acquired Gmarket last year, South Korea's largest online retailer.

The largest opportunity in Asia is obviously in China and its emerging market neighbors. China's largest online retailer, Alibaba Group, has trounced eBay's online retail attempts in the country. So it was a surprise when Alibaba recently added PayPal as a payment option on its online business-to-business site Ali Express. Ali Express connects merchants outside of China with suppliers within the country. While this deal may not provide access to China's large and growing consumer base, its recent deal with China UnionPay just may. China UnionPay is a fast-growing bank card company in China with 2.1 billion cards issued. PayPal will now be an option for CUP card holders when making purchases online.

In the near term, growth may be muted by what eBay CFO Bob Swan called a "dramatic slowdown" in cross-border trade among the U.S., Europe, and Asia in last week's conference call. The second half of the year may be less than spectacular, but over the next several years we expect PayPal to continue its double-digit growth rates. Online retail in developed markets outside of the U.S., especially in Europe, should continue to grow. And at eBay's current stock price -- 11 times earnings and 12 times free cash flow -- we are buying a stock without much growth priced in.

Competitive advantage
Historically, eBay has benefited from a very strong network effect where each additional buyer attracted additional sellers and vice versa. But in the U.S., the online retail market has drifted away from the auction format while simultaneously expanding because of the Internet's low barriers to entry. As online retail expands, eBay faces intense online competition from the likes of Amazon.com (Nasdaq: AMZN  ) and big-box retailer Wal-Mart's (NYSE: WMT  ) Internet site. Internet search giants Google (Nasdaq: GOOG  ) and Yahoo! (Nasdaq: YHOO  ) also function as shopping portals that direct users to stores, similar to eBay.

In terms of competitive advantage, the torch has been passed to PayPal, where its network effects are still strengthening because of its global expansion and growing brand recognition. More than 75 percent of eBay purchases in the U.S. are done with PayPal, and more than half of the largest merchants in the U.S. offer PayPal -- more than double the ratio of any other country. PayPal also benefits from higher barriers to entry than eBay's retail sites because of various government regulations for payment processors. Just ask global money mover Western Union (NYSE: WU  ) , which staffs 400 employees and spends about $40 million a year just on regulatory compliance.

While you can count on PayPal's growth in the U.S. and Europe, where its share of online transactions is still less than 15%, growth in China may be much more difficult. Strict government oversight, virtually no brand recognition, and an established direct competitor in Alibaba's Ali Pay will be tough to overcome.

Management
Longtime CEO Meg Whitman stepped down in 2008, leaving the task of reviving a struggling online retail business to new CEO John Donahoe. Donahoe has run the retail business for about five years now and is attempting to change consumers' perception of the auction site with a greater emphasis on fixed-price shopping. Donahoe first tested the strategic shift in the U.K. and Germany and has had success. In the second quarter, strong retail sales in Europe were a bright spot, helping the company beat analyst estimates.

Chairman and founder Pierre Omidyar owns about 12% of the company while Donahoe owns less than 1%. We think management is properly aligned with shareholders' interest. The major concern for shareholders is how management spends its near $5 billion in cash. Historically, management has had its ups and downs with acquisitions -- PayPal was a huge hit while Skype was a bit of a mess. We hope management focuses on repairing its online retail business while growing PayPal and building its competitive advantage.

To get our exclusive content on eBay and access to our updated buy, sell, and hold recommendations on all 90 companies on the Stock Advisor scorecard, take a free trial of Stock Advisor. In the meantime, let us know what you think of eBay in the comment section below. Does it make your buy list?

Bryan White doesn't own any shares of the companies mentioned. He works for the Stock Advisor newsletter service. Wal-Mart Stores and Western Union are Motley Fool Inside Value choices. Google is a Motley Fool Rule Breakers recommendation. Amazon.com, eBay, and Western Union are Motley Fool Stock Advisor picks. Motley Fool Options has recommended a bull call spread position on eBay. Motley Fool Options has recommended writing covered calls on Western Union. The Fool owns shares of Google. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 28, 2010, at 3:13 PM, RicRoe wrote:

    One would have to be mad at their money to buy into eBay now.

    eBay's CEO admits that eBay.com is not generating sales and growth is stalled. This is primarily due to massive system and policy changes over the past two years.

    Buyers and sellers reaction to the destructive changes has been to move their buying and selling to other venues. One need only look at Amazon's double digit growth to see where business is these days.

    Despite the destructive system and policy changes which have damaged eBay's marketplace, John Donahoe continues to roll out one ill conceived change after another and continuing to alienate buyers and sellers.

    To demonstrate how out of touch eBay's CEO is with his customers, he recently announced that search algorithms would be tweaked so as to favor higher priced goods. Apparently Mr Donahoe has forgotten the fact that buyers came to eBay looking for bargains, not higher priced items.

    eBay's huge fee increases this year have alienated sellers, and remaining sellers were forced to once again raise prices. This yearly upward spiral has all but killed the value proposition for shopping on eBay.

    One should also consider the numerous class action suits pending against eBay at this time, one of which is seeking 3.8 billion dollars. Should eBay lose one or more of these actions, the toll on eBay's value would be huge.

    If you are considering buying into eBay at this stage of the game, the downsides outweigh the upsides.

    While PayPal may be generating high profits, the company value is not based solely on PayPal.

    Unless or until there is a complete change in management at eBay, the marketplace appears destined for the scrap heap, and the value of eBay stock is questionable at best.

  • Report this Comment On July 28, 2010, at 4:10 PM, Austin57129 wrote:

    ricroe,

    You missed the entire point of the article Motley Fool was attempting to provide. They've acknowledged eBay has some issues to clean up however when a child company is growing 30% to 40% year over year whats going to happen? They are going to outgrow eBay and they will generate most of the revenue!

    PayPal has been trouncing other online payment options abroad and with PayPal accepting less than 15% of all online payments it has a great chance to grow online.

    PayPal also opened up it's back end API to developers which allows PayPal to be everywhere payments are made. You never know, that store your swiping you card could be using PayPal as a processor allowing PayPal to be used for face to face transactions! There's so much upside to PayPal, most online vendors are looking to expand it features online when PayPal is looking to expand everywhere!

    Look for PayPal to outgrow eBay in revenue within the next 5 years with continued 20% to 30% growth year over year. Hopefully other analyts are paying attention to PayPal because it's just getting started.

  • Report this Comment On July 28, 2010, at 4:39 PM, RicRoe wrote:

    With eBay being sued for $3.8 Billionin a patent dispute, the current and future profits at eBay are at risk.

    If by some chance eBay loses this suit, then the entire PayPal operation would be in jeopardy.

    As PayPal is doing all the heavy lifting, and as eBay continues to alienate users, I see nothing but downside here at least until such time as the case against PayPal is decided.

    Details of the lawsuit can be found here: http://tw0.us/LXl

  • Report this Comment On July 28, 2010, at 4:56 PM, TMFCaccamise wrote:

    @RicRoe,

    I knew there would be a good debate. eBay's marketplace biz does about 40% operating margins. Even if it slowly dies they'll push thru a ton of FCF in the meantime while PayPal grows its network. At its current price investors are NOT paying for a growing marketplace biz.

    As far as the lawsuit goes they have about $5 billion in cash on the balance shee t and no debt so it wouldn't really hurt operations. That said who wants to give up $5 bills in cash? Not me!

    I completely understand the user outrage against eBay over the past couple years and I think the market has certainly priced in waning user loyalty.

    Another note for investors to keep in mind is that PayPal's margins are about half of its marketplace biz. PayPal's revenue should catch up with eBay's marketplace revs in a couple years, but it'll be awhile longer for PayPal's profits to match up with marketplace's. We are not worried the marketplace isn't going away tomorrow.

  • Report this Comment On July 28, 2010, at 9:49 PM, NYMArts wrote:

    David Gardner needs a psychiatrist.

    He's insane. And if he puts his own money on Ebay, he won't even be able to buy a clue.

    I'm guessing he's doing a Goldman Sachs. Going short on Ebay stock behind the scenes. We don't play that.

    Ebay is dead and buried.

    Nobody mentions it anymore, except to relay how bad it is.

    Gardner is in need of a 2 year sabbatical to clear his head.

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