Rule Breaker Portfolio eBay's Cash Isn't Flowing

eBay's first-quarter earnings had a lot of strong points, like expanding margins, higher expectations, and strong increases in gross merchandise sales and revenue. There are clouds, however. Cash flow is being hampered by swelling current assets; expectations from management and fawning observers may be running out of control; and Nixonian gaps are appearing in conference calls.

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By Brian Lund (TMF Tardior)
April 23, 2001

Call me churlish, call me childish, call me Tardior, but I became really uncomfortable last week after eBay (Nasdaq: EBAY) released its fourth-quarter results. It's not that I thought the results were bad (though I have my reservations, as I'll explain in a moment), it's that the response to them among commentators, analysts, and the market seemed excessive. When everyone else is optimistic, it's time to be skeptical.

Friends, Fools, countrymen, lend me your ears -- er, eyes. I come to bury eBay, not to praise it.

First-quarter results
You've probably heard the spiel. Everyone loved the results. Here are just a few of the headlines:

"eBay Looked Invincible in Q1"
"Investor Fave eBay Delivers Once Again"
"eBay Q1: A Veritable Sunshower"
and the Fool's own, "eBay Beats Estimates, Raises Guidance"

All right, that last one isn't very colorful, but the rest of them are downright rhapsodic. Far be it from me to criticize others for rhapsody, however. I'm guilty of the same kind of unbridled optimism about eBay's future. I've even called it undervalued -- of all things! It got so bad that I told myself I would take a break from writing about the company, just as soon as earnings season passed. Really I will.

I have sympathy, then, for those who succumbed to the urge to fawn after seeing eBay's first-quarter results. Net margins reached 13.7%. Pro forma net margins, which don't include icky non-cash charges like amortization and stock compensation, were almost 20%. Both those numbers are way up from a year ago. Revenue, too, rose 90% over last year's first quarter.

The really impressive number to me was gross merchandise sales (GMS). GMS approached $2 billion for the quarter, up 72% from $1.1 billion a year ago. $2 billion. That's about the same amount of sales as Amazon.com (Nasdaq: AMZN) had in the last three quarters combined.

Growth, growth everywhere
The growth is occurring across the board, too. eBay said that its GMS in U.S. books, music, and video operations on the home site and especially on its subsidiary Half.com grew to an annualized run rate of $700 million. It experienced 20% sequential growth in Amazon's core business, where sales have stagnated lately. (And don't think that eBay didn't want us to make that comparison.) Sales in this segment have already reached 40% of Amazon $1.7 billion annual revenue in 2000.

The company's collectable business grew 20% too, but it is becoming less and less of eBay's core business. What the company calls "practicals" now account for half of GMS. eBay Motors accounted for 13% of GMS, or $260 million, up 40% sequentially. Who would have thought that eBay's used car sales would be on a run rate to reach $1 billion this year?

There are lots of other positive developments, but this is supposed to be a funeral. Let me get to the criticism portion of the evening.

Growth doesn't pay the California electricity bills -- stock options do
Growth and 14% profit margins are nice and all, but what we really want to see is cash flow, and I don't think eBay's will be very pretty this quarter. We haven't seen a statement yet, but current assets on the balance sheet were way up, which doesn't bode well.

eBay's accounts receivable have been rising along with sales, which is understandable, but the category of "Other current assets" is sapping the life out of eBay's cash flow. I don't know what this category represents (I couldn't get in touch with investor relations last week; I'll be trying again this week), but the figure rose $25 million this quarter -- almost equal to eBay's pro forma net income. If the latter represents operating profit after taxes, the former just wiped it off the cash flow statement.

This happened last year, too. Net income contributed $48 million to the cash flow statement, and "other current assets" ripped off $40 million. The result is that eBay's Foolish Flow Ratio has risen steadily from 0.90 last year to 1.33 this quarter. Cash just isn't flowing as well as it should.

Nothing on the liabilities side of the balance sheet this quarter will compensate for the $25 million cash loss to "Other current assets." In fact, accounts payable fell noticeably. eBay says that it generated $40 million in cash from operations this quarter, however. Where did it come from? Tax benefit from stock options, everyone's favorite operating cash flow item that has little to do with operations?

That's not good enough. When I find out what "Other current assets" are, I'm going to insist that eBay do its darnedest to staunch the bleeding. I don't mind capital expenditures hurting free cash flow, but I don't want to see this situation continue.

Ever-higher expectations
The other thing that bugged me this quarter was more cosmetic. It was that eBay rose revenue estimates by about 5% for the next two quarters. Why do companies insist on doing this, for Pete's sake? Beating estimates by 5% is a nice upside surprise. Why raise expectations unnecessarily?

We recently had eBay CEO Meg Whitman on Motley Fool Radio. She had previously made the audacious estimate that eBay would reach $3 billion in revenue by 2005 -- a 50% annual growth rate. It was a bold call that put a lot of pressure on the company. David Gardner asked her why she did it. She said that she wanted the Street to appreciate more fully the company's potential. Why? Who cares if the Street doesn't get it? Just do your job, Ms. Whitman. Let the stock price sort itself out.

As things are, "the Street" is bound to start worrying about revenue growth soon. The year-over-year growth rates are expected to slow to about 50% by the end of this year. If that happens, investors will reiterate their doubts that eBay can reach its goal. I ask again: Why introduce the whole melodrama?

The missing three minutes
There was one other curiosity. When I was listening to the conference call on eBay's site, I ran into a three-minute gap, between 35:00 and 38:00 in the call. It started as Whitman asked for the next question, and it picked up just as the question was finishing.

"How odd," thought I. I went to Vcall.com, which hosts some conference calls, and listened to it there. It turned out that the missing question belonged to Holly Becker, the Lehman Brothers analyst who has openly cast doubts on eBay's valuation and growth rate. They didn't get into a fight or anything, but Becker did ask a couple of pointed questions.

I haven't talked to the company about this, but I sure hope that eBay's not editing its conference calls. That's not forthright management, and we want forthright management in our companies. We wouldn't invest in Nixon.

Note: In a discussion with the company after publication, the omission was attributed to an error on the part of the conference call company. The operator apparently hit a wrong button. Investors would be served by a note telling them to listen to the complete call on Vcall.

Wrapping up
Sure, it was a nice quarter and all. eBay is executing, and Half.com is looking fantastic, though it has yet to become profitable (the fact of which was the essence of Becker's question). There is lots of work to be done, though. Success is not a lock. Don't get carried away by the paeans that folks -- even Fools, even me -- are singing about eBay. Keep your eyes and ears open.

Brian Lund is an eBay shareholder and plans one day to sell his corpse on the site -- or maybe on Half.com. To view his portfolio and casket (feature to be added soon), check out his profile. The Motley Fool is investors writing for investors.

Rule Breaker Portfolio


4/23/01 as of ~4:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AMGNAMGEN INC0.390.65%59.95
AMZNAMAZON.COM0.422.66%16.20
AOLAOL TIME WARNER INC(1.09)(2.24%)47.60
CRAAPPLERA CORP - CELERA GENOMICS(2.50)(6.74%)34.61
EBAYEBAY INC(3.70)(7.31%)46.95
HGSIHUMAN GENOME SCIENCES(4.61)(7.69%)55.34
SBUXSTARBUCKS CORP(1.23)(3.06%)39.00

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(8/5/1994)
Annualized
Rule Breaker(3.14%)(3.14%)17.71%13.14%425.41%28.01%
S&P 500(1.50%)(1.50%)5.52%(7.27%)167.09%15.75%
S&P 500 (DA)(1.42%)(1.42%)5.22%(6.92%)181.35%16.64%
NASDAQ(4.81%)(4.81%)11.91%(16.64%)185.95%16.93%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (8/5/1994)
Rule Breaker33.28%
vs. S&P 50015.18%

Trade Date # Shares Ticker Cost/Share Price Total % Ret *
8/5/944020AOL0.4547.605332.01%
9/9/971320AMZN3.1816.20511.48%
12/16/981160AMGN21.4459.95179.56%
7/2/98470SBUX27.9539.0039.51%
2/26/991145EBAY46.5546.950.87%
12/17/991260CRA39.7634.61(12.94%)
9/22/00560HGSI80.0555.34(30.87%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain *
8/5/944020AOL$1,816.44$191,352.00$262,128.00
9/9/971320AMZN$4,204.20$21,384.00$56,690.90
12/16/981160AMGN$24,875.50$69,542.00$44,666.50
7/2/98470SBUX$13,138.62$18,330.00$5,191.38
2/26/991145EBAY$53,294.44$53,757.75$463.31
12/17/991260CRA$50,093.00$43,608.60($6,484.40)
9/22/00560HGSI$44,830.50$30,990.40($13,840.10)
 
Cash: 
Total: 
$18.42
$428,983.17
 

* Our long term totals include both our realized and unrealized gains. For instance, we have sold portions of AOL and Amazon in the past, and those realized gains are included in our total returns for these stocks.



Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.