FOOL ON THE HILL
eBay's Soft Underbelly

RBC Capital Markets analyst George Sutton says large sellers are expressing concern about three aspects of eBay: lower demand for mass items, poor traffic in eBay Stores, and PayPal's independence once the acquisition closes. Another analyst, however, sees an entirely different scenario.

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By Rex Moore (TMF Orangeblood)
October 2, 2002

Stop me if you've heard this before: "I love eBay's business model, but the stock is waaay overpriced." It's a constant refrain in the investing world; we hear it more often than the National Anthem at baseball games. Yes, the business has been awesome, growing dramatically since its IPO in Sept. 1998, and it's one of the rare dot-coms that has not only survived the crash, but actually thrived.

And yes, the share price has been up and down more than Mike Tyson in his last fight; you could've bought in as low as $5 (split-adjusted) in the early days and sold as high as $100 several months later. (Ah, hindsight.) Now sitting at about $50, eBay's (Nasdaq: EBAY) current P/E is north of 100, and its price-to-free cash flow (P/FCF) is 72. Looking ahead, the stock is trading at 44 times next year's estimated earnings.

There's never been any question that the company is richly valued, but investors have banked on management's vision for growing it into one of the most dominant buying and selling platforms in the world.

Now, however, at least one analyst is seeing some possible weak spots in eBay's heretofore impenetrable armor. George Sutton of RBC Capital Markets says some red flags indicate the auction king's business may be about to slip.

Make no mistake... it's usually in a Fool's best interest to ignore analysts' advice. The conflicts of interest they face are incredible, and their fraudulent practices are well documented. But Sutton is not trying to win any investment-banking business here, and his concerns are reasonable. Let's look at his major points.

Liquidation troubles
Will prune juice help? As an eBay shareholder, I've long kept an eye on the number of large companies that use the site to liquidate inventory. In my mind, this is one of the major long-term revenue drivers. After all, it takes an awful lot of small sellers to create the same impact as a company that unloads hundreds of computer servers each week.

Sutton said in a research note that he has spoken with several such big sellers, and they're telling him that eBay "does not operate well as a vehicle to sell large volumes of the same product and, in fact, some have found that the demand eBay could create through auctions pales in comparison with the amount of product which could be made available."

For these companies, supply is exceeding demand, and Sutton says many are seeking alternatives such as Amazon.com (Nasdaq: AMZN) and Yahoo! (Nasdaq: YHOO) auctions.

Storefront disappointment
eBay Stores launched about 16 months ago with great fanfare. The idea is to allow sellers to offer merchandise in a fixed-price format within a "storefront" setting. A spokesman called it the next logical step in the company's evolution, and a good way of extending the eBay brand and platform. Currently, over 30,000 people pay a fee to operate a storefront.

Not everyone thought the idea made sense, however, including albaby1 and UsuallyReasonabl on our discussion boards. And less than two months ago swapusa, an eBay Powerseller, declared the storefronts "worthless."

Sutton's research has turned up similar sentiment. Apparently the stores are just not bringing in the traffic most sellers hoped for.

PayPal independence
eBay's planned acquisition of online payment provider PayPal (Nasdaq: PYPL) has drawn mostly praise. With PayPal as the dominant payment choice among auction winners, eBay did all it could to knock it off -- but failed miserably. So, unable to whip David, Goliath bought him out instead.

But Sutton says many sellers are questioning how beneficial PayPal will be once it loses its independence from eBay. Again, this was a concern expressed on our discussion boards as soon as the deal was announced. Long-time seller OOLFAY, who was able to retire from his "day job" because of eBay profits, is worried that management will raise fees now that they've eliminated competition.

What may hurt the anticipated revenue stream from PayPal, according to Sutton, are users opting for alternative payment options. He cites c2it, a free service from Citibank (NYSE: C), as one to watch out for. PayPal gained its current status as a mostly free service, so it's not unreasonable to think another outsider could come in and make some waves.

Consequences
If it's true that there's lower demand for liquidated items, disappointing traffic in eBay Stores, and trouble ahead for PayPal, then earnings will suffer in the months to come. But the most troublesome thread running through all this is the possible discontentment of major sellers. Should a significant number of them pack up and leave, we'll see worse than just a slight earnings disappointment.

While such a scenario may be possible, it's also unlikely in my opinion. eBay has gone to great lengths to attract businesses and major sellers, and management is unlikely to sit on its hands and watch them drift away. There's also no question that many are very successful on the site. Of those who are experiencing disappointing sales, very few will do any better on Yahoo! or Amazon; both combined cannot come anywhere near eBay's total of 50 million registered users.

It would also be rather shortsighted for management to abuse its position once the PayPal acquisition is finalized. Certainly CEO Meg Whitman and her crew have made some mistakes along the way, but don't expect them to create an environment where another outside service like c2it can flourish.

After all that...
To demonstrate just how hard it is to get a handle on these issues, another analyst -- WR Hambrecht's Derek Brown -- issued a report yesterday that directly contradicts Sutton's research. Brown says he has an "overwhelming sense" that big companies like IBM (NYSE: IBM), Motorola (NYSE: MOT) and Sears (NYSE: S) are "slowly moving eBay's way," ready to use the platform as a channel to unload excess inventory and refurbished merchandise.

eBay has thus far sailed through both a good and bad economy, growing stronger each quarter. The bottom line, though, is that its shareholders now have some issues to keep an eye on.

Rex Moore finished this column around 2 a.m. while the St. Louis Cardinals were wrapping up a 12-2 victory over the Arizona Diamondbacks in the opener of their National League Division Series. As seen in his profile, he owned shares of eBay at press time. The Motley Fool's disclosure policy is certified dolphin-free.