Rule Breaker Portfolio

Rule Breaker To Buy eBay
February 25, 1999


**This trade is being made under the regular portfolio policy, namely, once The Fool announces an intention to trade, that trade will be made within the next five market days. For more detail, please read the "New Trades" section of the Rule Breaker Portfolio.**

At some point in the next five market days, The Rule Breaker Portfolio is BUYING $30,000 of:

eBay Inc. (Nasdaq: EBAY)
http://www.ebay.com

Price (2/25/99): $299 1/2
Average daily volume: 1,458,000 shares
Daily dollar volume: $436 million

Market Cap: $12.06 billion
Sales: $47.35 million
Price-to-Sales ratio: 254

eBay Quote I eBay Snapshot I eBay Chart
eBay Financials I eBay Estimates I eBay News


Another "Internet Stock?"

INTRODUCTION

What is an Internet stock? And what isn't?

That is the question investors should be asking, and that is what we asked ourselves.

Almost every public company is building a presence on the Internet. But so what? What's most important in any industry is: which companies are dominating? Which companies stand to gain the most in the long term? Which are able to leverage a position to grow earnings beyond their expected potential? Which are leaders and which are laggards?

Finally, which matters more -- the medium in which a company operates, or that company's business potential?

Obviously, the latter.

Yet the media seem obsessed with derisively painting businesses that begin on the Internet as "Internet companies." Hard at work, tarring with a broad brush, these commentators have failed to notice that virtually every business is working to utilize the power of the Internet and to develop a presence on it. In the future, the ersatz "Internet company" distinction will melt away. What is much more important, even now, is that a company lead its industry (whatever that industry may be) and that the company stands to profit in the long term.

And what of the Internet itself?

This medium offers the opportunity for almost every industry to be redefined, reconfigured, and reestablished, and for new rulers to step up and dislodge the old. This is the potential for which smart managers of new companies are reaching. This is the potential that Amazon (Nasdaq: AMZN), Yahoo! (Nasdaq: YHOO), and America Online (NYSE: AOL) have seized in countless ways: the potential to redefine how we shop, learn, communicate and transact. New companies are working to seize these new markets. These are New World Economy companies (rather than "Internet companies") that are working to capitalize on potential that has never before been present to such a scale.

The Oldest Business That Ever Was

#1: TOP DOG AND FIRST-MOVER IN AN IMPORTANT, EMERGING INDUSTRY

This company has redefined the oldest business that ever was -- the open market.

eBay has been public five months and is already well known. It's been written about extensively and its stock has soared sixteen-fold from its initial offering price. It is the top dog, first-mover auction site on the Internet, with more auctions taking place on its site than on all the competition combined. The site has had over 50 million items offered for sale since inception, it has 1.6 million items for sale right now (at www.ebay.com), and it was recently sainted the second-most visited Internet site (by time spent) on the Web, behind Yahoo!

eBay receives over 600 million page views per month and has close to 3 million unique registered users. Sellers on the auction site pay a small fee to place an item for sale (the fee depends upon the asking price for the item) and buyers pay nothing extra to buy. They merely need to be a registered user.

eBay has been profitable since its founding and reported 1998 revenue of $47.35 million, up from $5.7 million in 1997, with net income of $2.4 million last year. The company has very high gross margins -- over 80%. Gross margins represent what it costs the company for every dollar of revenue. With eBay, each dollar of revenue has cost $0.20, resulting in the 80% gross margins. This company has a giant advantage when it comes to margins because it doesn't carry inventory. It doesn't sell anything tangible. It provides the forum for a community to meet and conduct transactions. (Tom Gardner wrote about eBay's business model on January 28 in the Rule Maker Port.)

eBay is top dog in what it does and eBay was and is first mover on many industry initiatives, including having an accountable community of users where members rate each other to keep transactions on the level -- a service in which it excels because its community is so strong. The question remains, then, is this an important and emerging industry?

The answer that we propose is "Yes." Yes on two counts.

In its own right, eBay is redefining not just the auction market, but the entire retail market. Any person or entity can sell items over eBay, and because the site has reached critical mass, official companies and organizations do so as well; you can buy products directly from a manufacturer or wholesaler over eBay, cutting out any middleperson or end-retail component. But beyond the company's potential for upsetting traditional retail channels, eBay has created an entirely new market as well: a worldwide market for old and used items. This market represents most of eBay's bread and butter to date.

In the past, you needed to open a garage sale and hope that somebody in your area wanted your 1970 day-glo orange lava lamp. Now you can put that baby up for sale on eBay and more than likely find a buyer somewhere in the world. Everything from Coca-Cola collectibles, to Star Wars figures, to Mazda Miata cars sell on eBay. Sotheby's this is not. Exclusive this is not. eBay is a site for anyone and everyone. And, with recent agreements, eBay is ready to take its offerings officially international (although it already is international, of course), initially into Australia and New Zealand.

Why is this industry important? For one, it's endless in scope.

This world is made of used items and most of them are aching to be sold (and, oddly, bought). On eBay, the opportunity exists to sell the most obscure item that you own to a world full of interested buyers. The fact that eBay's auctions go so well already (over 70% of items listed are sold) is a testament to how successful the auctions should be when twice as many users are on the site; not to mention three times as many users; and four; and five; and ten. Eventually, you'll be able to sell almost anything over the Internet. All that you need is to find the right audience. And all that your potential audience needs is the right place to meet you. eBay has been named that place by popular demand. Now membership is growing by record numbers.

The long-term size of the world market for secondhand goods? You tell us.


When Strong, Communities Abide

#2: SUSTAINABLE ADVANTAGE GAINED THROUGH BUSINESS MOMENTUM, PATENTS, VISIONARY LEADERSHIP, OR INEPT COMPETITORS

Is eBay's business advantage sustainable?

eBay's business advantages may be more sustainable than those seized by Amazon, another first mover. Why? Because eBay's advantages are rooted in its strong community and in the feeling of trust that is engendered while you participate in its forum. You don't typically experience that immediate level of comfort, of legitimacy, and of safe-dealing on other auction sites. (And these are qualities that management can't simply create. The community has to agree to create them essentially from day one.)

Next advantage: The more you use eBay, the more likely you are to continue using it.

Whenever you buy or sell anything on eBay, the person with whom you transact is encouraged to rate you. Over time, your ratings become a badge of honor (or shame). The community respects those with high marks. In fact, people using eBay go beyond the call of duty, often, to make sure that they only get high marks when they make transactions. They avoid a bad mark at any cost. Once you've begun to build a reputation on eBay, and once you've begun to know other sellers and reputations, too, you're much more likely to use its auction service over others.

eBay has the early lead in building a reputable community. Its lead (and early momentum) serves very well in creating more momentum. Even spanking brand new auction participants are likely to know that eBay has the most reputable group of buyers, so they'll make eBay their first choice for business -- even if they've never been to the site before, and even if it's their first time online. (Many people have reportedly bought computers and gone online due to eBay alone: many people make a living selling items on the service.)

eBay's lead in technology and utilities, customer base, and community goodwill all make for formidable sustainable advantages. Meanwhile, its competition hasn't been able to create the same fervor for their offerings. Yahoo! (Nasdaq: YHOO), for example, recently opened an auction site, but it's generic and not nearly as well structured or "sale or purchase" friendly. Yahoo! is probably aiming for spillover auctions (the fringe market) as this is a minor part of its business, while eBay is the recognized top dog, focused only on auctions, and is growing faster than any competitor. That's key.

In this business, critical mass and then exceeding critical mass is critically important in the long term. Wherever you're most likely to sell an item is where you'll put it up for auction first. And you can only put an item up for auction on one site at a time, not several. eBay will be the first choice for most -- and the last choice.

Starbucks, Intuit, Disney, PepsiCo...

#3: GOOD MANAGEMENT AND SMART BACKING

Some of the most notable names backing eBay and on the board of directors are Howard Schultz, founder and CEO of Starbucks (Nasdaq: SBUX), and Scott Cook, founder of Intuit (Nasdaq: INTU). Mr. Cook is also a director at Amazon.com, as this Foolish message post shares (along with other thoughts on eBay -- thank you to everyone who posted the past few days).

eBay executives are also coming to the company from Disney, PepsiCo, Macy's and Hasbro, among others. eBay's management can be read about here, on its website.

Management is a difficult, subjective quality to measure, but eBay has very successful investors behind it -- beyond the heads of Starbucks and Intuit -- and the company's past performance (though brief) points to a very "with-it" management. While leading its industry hands-down, the company has dealt candidly with growing pains (more on that when we talk about Principle #6) and on issues such as firearm sales and lawsuits resulting from failed or fraudulent auctions.

Is management adept? Flip that around. If management weren't adept, they wouldn't have grown to become the second-most visited website so quickly, by various measures (unless they had extreme luck), nor would they lead a niche that is rife with competition. Plus, they wouldn't have accomplished this with relatively little marketing costs. eBay management has shown efficient skill managing growth and crisis, while growing its business through visionary planning and by offering a service that creates a buzz among consumers (more on that in the brand name section). eBay management could be breaking the rules -- and at the same time, making them -- for its industry for years.

Stronger than a Locomotive

#4: STRONG PAST PRICE APPRECIATION MEASURED BY RELATIVE STRENGTH OF 90 OR MORE


This one is easy.

The company was priced at $18 per share (after an increase due to demand) on September 25, 1998. The stock opened at around $50 per share, closed at $44 7/8, and has never traded below $25. Instead, eBay has since risen as high as $321 (on January 8, 1999) and is currently at $299.50. Yup, we're buying into this stock at a "very high" price compared to where it began and where we first began to look at it.

On the bright side, the stock's performance easily puts it at a 99 relative strength, meaning that it has outperformed 99% of all stocks on the market since being listed. That's a good sign of the market's confidence in eBay over its competitors. Yes, it's also a result of the recent rapid run-up in Internet stocks, but the fact that eBay rose in value much more than other Internet stocks is actually a good sign to us. An industry leader will always trade at a premium to peers. Think Coca-Cola vs. Pepsi; Yahoo! versus every other portal; Cisco versus 3Com, Amazon versus ... whatever. (It's hard to pin down Amazon any more: drugs, books, music, electronics, toys.)

Anyway, akin to other niche leaders, eBay trades at a great premium to peers such as uBid (Nasdaq: UBID), which has seen its stock get whacked, and ONSALE (Nasdaq: ONSL). As long as eBay is the Top Dog (category killer) and is growing, this will probably remain true. For how long can eBay grow? The Internet is still an infant.

Second Most Frequented Website

#5: THE GREATER THE CONSUMER BRAND, THE BETTER

This is again subjective, but eBay has a strong consumer brand that is growing rapidly by word of mouth. Like Amazon, eBay is creating a buzz in both the online and off-line world. Much of the best promotion for eBay and much of its brand-image is being created for free as a result of this buzz. That gives it an immeasurable advantage over lesser-known (and lesser-talked about) competitors. (For an example of eBay being talked about in other mediums, see this Fool's post about eBay on television shows.)

When one hears about auctions on the Internet, eBay is almost always, by necessity, mentioned. eBay is almost always, by necessity, mentioned. It's the Yahoo!, the Amazon, and the AOL of what it does. eBay is already the leading auction brand online, and it's advertising on radio and elsewhere to get its name known by the masses.

And how does eBay gain interest from people who have never heard of it?

To its great benefit, eBay provides instant utility and means for profit to almost anybody in the world, making its radio ads very effective. Almost everybody in the world possesses something that he eventually wants to sell, along with several items that, when considered, he'd equally like to buy. The notion of eBay making either transaction possible is exciting to a non-eBay user who hears a radio ad. By contrast, a person typically doesn't get excited when he hears an ad from a more traditional Internet service, such as a search engine. But eBay offers instant potential for profit, or the possibility of buying something you've always wanted but couldn't find. That catches ones attention and keeps it.

eBay is now one of the most visited sites on the Web, so its brand name is destined to continue to gain awareness. A cover story regarding eBay was run on CNN last week -- eBay's story is beginning to snowball.

Two Paths Diverged in a Wood

#6: A SIGNIFICANT MEDIA CONSTITUENT HAS RECENTLY CALLED IT OVERVALUED

Another significant and promising criterion in searching for Rule Breakers is this: the media have recently criticized the company for problems related to growing pains (just as they criticized AOL for poor service in the past) by playing up recent complaints of website shutdowns at eBay.

That the media makes news of such events is a positive sign in and of itself. It means that the companies under fire are growing at breakneck speed, and that they're beginning to matter in the daily lives of millions. Otherwise, the company problems wouldn't be news. The news also serves to increase awareness of the company, with more attendant long-term positives (such as name recognition) than negatives.

Another angle of the above criterion to seek out is this: The media reports extensively on news related to the Rule Breaking company regardless of its merit, and especially when it is negative. This can also mean that the company has entered the mindset of popular culture, has created buzz for good reason, and likely has strong potential. eBay has recently been over-covered in the news for fraudulent auctions, gun sales, and technology glitches.

Great sign!

As for being called overvalued: eBay has had that for months. Just this week an analyst was quoted as follows after an eBay presentation:

"'I wanted to see them justify their valuation,' said Loren Lopin of Harbor Ventures. 'And they didn't do that.'" According to a journalist, Lopin sees eBay as an entertainment site, not a sustainable e-commerce business.

In late December the San Francisco Chronicle marveled at the company's $12 billion value, comparing it to Clorox and Apple Computer ("three times the price of Apple"). Many journalists have cited eBay's valuation with implied smirks of criticism. Let's face it: almost everybody thinks that this stock is overvalued.

We take this as a good sign (a contrarian sign) if it means anything at all.


Our Riskiest Investment -- Ever

CONCLUSION

It isn't our prerogative to convince anyone else to buy a stock -- not at all. We aim instead to explain why we're buying. So, why are we?

Are we nuts?

We first talked about eBay at around $50 per share, and heck... that was just three months ago. It's now five times that price. (It rose $13 today alone, and it has gained $87 in the last two weeks.)

Whatever the shares do, without question we realize that this is our riskiest investment to date. It is in many ways much riskier than our purchase of Amazon.com in 1997.

Why?

For one, we've arrived to this stock much later. Sure, we bought Amazon about five months after it came public, and we're buying eBay five months after it came public. However, we bought Amazon when the company had a total value of $880 million; eBay is already valued at $12 billion. So, obviously we won't enjoy the multiplying of our eBay shares in the same way that we have with Amazon, or with America Online -- which was bought in 1994 when the company was valued at around $240 million.

In fact, eBay could be valued at half this price in a matter of months or -- more frighteningly -- years. This valuation allows for that kind of failure. But there is also great enough upside potential that we're willing to invest in the company, long term, and we obviously believe (or we wouldn't buy it) that this Rule Breaker can make the investment worth our while. Plus, realize that we're investing only about 5% of the portfolio in this company and we're not -- as always -- using any margin. Our risk is limited to what we're investing. Yes, we want to be partial owners in what is already the largest auction house in the world by users. We believe in the company's long-term potential to scale, to use this new medium to unforeseen advantage, to continue to be able to leverage its inventory-free business model, and to continue to operate with growing profitability. But we know our risk limits, too. It's 5% of the portfolio.

How large can a worldwide auction market be? As we've said before: you tell us. This is a new industry -- or, more accurately, an industry made anew. Just as Amazon is remaking the retailing industry and consumer shopping experience, eBay is redefining the auction, flea market, garage sale, and even retail world.

We trust that, as Fools, you'll do your own research and take your sweet time (as you should) in all of the investment decisions that you make. (Plus, regarding eBay, we don't want to pay a higher price than we already have to, so we hope that the stock stays flat -- or goes down! -- following this announcement.) If you're interested in eBay at all ("WHAT'RE YA, NUTS?"), begin by visiting the site at www.ebay.com. Search for an item. See the variety of items for sale. Flip around the site. Learn it.

To close, let's repeat: eBay will represent about 5% of the Rule Breaker portfolio when it's purchased; we don't use margin; we're long-term investors; we understand the high risk and we accept it. And we can accept the risk without putting us at great risk overall. We also accept the reality that valuing this company is very difficult and -- as with any true Rule Breaker -- we haven't tried. Two years ago we tried to place a value on Amazon and we have so far failed miserably.

We'll be discussing eBay in future Rule Breaker columns, of course, hopefully for many (successful) years to come. For current discussion, please visit the Rule Breaker board.

Fool on!