Why eBay Spinning Off Paypal Makes Sense

Carl Icahn has been going activist on eBay (NASDAQ: EBAY  ) since Jan. 22, when he disclosed a position in the company and began lobbying for PayPal to be spun off as a separate entity. Icahn has had a very successful career of forcing companies to temporarily shift capital to ventures that build short-term shareholder wealth, greatly enriching himself in the process. Personally, I am not a fan of forcing a management team to use cash for buybacks rather than investing in the business or spinning off divisions just to get a quick payback at the expense of long-term stable growth.

However, Icahn has brought up several good points about conflicts of interest, and pointed out that the potential for competition with Apple (NASDAQ: AAPL  ) could weigh on the larger company's valuation if management doesn't act quickly. The increasing focus on eBay is actually revealing the potential future value of PayPal. If the company is spun off, it could do for eBay what Alibaba is doing for Yahoo! (NASDAQ: YHOO  ) .

Payments dragging down profit growth
In 2013, payments accounted for 41% of revenue, but with a lower gross margin than core marketplace  business and continues to act as a drag on profitability. As Gross Market Value increased by 10.6%, net income only increased by 9.5%, in part due to higher-margin core business growing more slowly than lower-margin payments business. 

Competition may increase dramatically
Apple has made it clear that entering the payments business is on its radar. Take this quote from the recent conference call:

The mobile payments area in general is one that we've been intrigued with, and that was one of the thoughts behind Touch ID. But, we're not limiting ourselves just to that. So, I don't have anything specific to announce today, but you can tell by looking at the demographics of our customers and the amount of commerce that goes through iOS devices versus the competition that it's a big opportunity on the platform.

Apple has 600 million iTunes accounts, each one with a credit card tied to it. Considering the potential impact of that on PayPal's business outside of eBay, it should concern shareholders who want a specialized management team to fend off that threat.

The other issue outstanding is board effectiveness 
Marc Andreessen did personally profit by being a part of the venture group that purchased a majority interest in Skype from eBay. The group sold the investment to Microsoft only 18 months later for more than three times the price. It's questionable about how much value the VCs could have brought to the table in such a short period of time to warrant an increase in value from $2.75 billion to $8 billion in less than two years. Other conflicts of interest were also brought up in Icahn's letter to eBay shareholders, but this was the most glaring. I'm not suggesting that this was a deliberate attempt to profit from eBay's ignorance, but independent directors are paid to share their industry insights from working in other facets of the field. And in this case, there doesn't seem to be enough guidance from the board.

eBay's Alibaba
In 2005, Yahoo! invested $1 billion for a 40% stake in Alibaba. This could end up being the investment of the decade when Alibaba goes public later this year and this stake is monetized for many times what was originally paid. According to the Wall Street Journal, some analysts are expecting a valuation of as much as $100 billion for the IPO. Oddly, something similar could happen with eBay. If eBay were to spin out a majority interest in PayPal, the company may be able to operate more effectively from a margin standpoint and expand its relationships with retailers like Target who are looking for a safer payment platform.

PayPal's revenue grew 19% in 2013 to $6.6 billion, according to the recently filed 10K. If eBay were to spin off PayPal with a net margin of 20%, and if the market awarded a multiple of 30, the company could be worth over $45 billion as a stand-alone entity. Since eBay's marketcap is only $76 billion, the spin off seems to make sense.  

PayPal was acquired in 2002 for $1.5 billion. Unlike the Silverlake venture, eBay grew the business over the next decade and appears to have the potential to spin it off for approximately $50 billion. That's not a bad investment!

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