Rule Breaker Portfolio eBay Stronger Than Ever

eBay's second quarter improved in several of the areas that had caused concern in the first quarter. The company easily beat its raised revenue estimates and raised them for the rest of the year. It slowed the growth in "other current assets" and lowered its Flow Ratio to 1.02, even though growth in receivables exceeded sales growth. Its free cash flow -- minus option benefits -- has never looked stronger. Expectations are high, but eBay is executing.

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By Brian Lund (TMF Tardior)
August 24, 2001

It has been three months since I last wrote about eBay (Nasdaq: EBAY), which I think is pretty good. At that time, I discussed a couple of items in the company's first-quarter earnings that caused me some concern. Now that the 10-Q is out for the second quarter, I'd like to take a look at those same elements in those numbers and see whether problems I saw in Q1 continued in Q2.

1. Ever-higher expectations
One thing, I'll tell you at the outset, hasn't changed: eBay continues to put pressure on itself to hit higher and higher revenue targets. CEO Meg Whitman has famously said that the company will increase revenues to $3 billion by 2005, a 50% annualized growth rate. I don't like the idea of creating that kind of ambitious, somewhat arbitrary goal. I don't really see the point to it.

Last quarter, eBay said that revenues would come in $10 million to $15 million higher than expected. I thought that this 5% adjustment was unnecessary. Well, eBay brought in $180 million for the second quarter, beating revenue estimates by $15 million, so I guess they undershot. Management now says that revenue for the second half of 2001 should be $15 million to $30 million higher than previously expected, or $385 million to $400 million for the two quarters. That would mean at least a 56% year-over-year rise.

All right, if that's the way eBay wants to play, I'm going to ratchet it up a notch. I've decided that eBay isn't putting too much pressure on itself, but not enough -- it's beating estimates too easily. I think that $400 million for the rest of the year is a low-ball figure. I expect to see revenues of $200 million in Q3 alone, with the Q4 holiday quarter reporting at least $220 million. For me, $420 million is the minimum acceptable figure for the rest of the year. eBay had best not fall short of my expectations.

Take that.

2. Swelling current assets
Another problem I had in Q1 was that current assets had begun to swell, driving the company's Foolish Flow Ratio up from 0.90 to 1.22 year-over-year. The main culprit was a sharp rise in "other current assets" on the balance sheet. In a discussion with the company, I learned that the main cause of that rise was $16 million in restricted cash from the purchase of a Korean auction site. eBay proceeded to break out that line item in its 10-Q for Q1.

Since then, the "other current assets" line has cooled down, growing only minimally this quarter. Accounts receivable, however, grew 37% sequentially, compared to 17% revenue growth. There was unusually high growth in receivables in last year's Q2 as well, so it may have something to do with season (though I can't say what), but it is the continuation of a steady trend.

Days sales outstanding have risen steadily from 37.2 days a year ago to 44.6 days this quarter. It is now at its all-time high. Days payables outstanding, meanwhile, have declined from 97.2 days to 84.2. This may have something to do with the addition of Half.com and Buy It Now, the company's fixed price initiatives, which now make up 11% of gross merchandise sales (GMS). Still, it is a change that eats into cash flow.

That said, the Flow Ratio looked better this quarter, dropping back to 1.02. Last quarter's rise was an anomaly, as eBay had said it was. There are still improvements to be made, but the situation is not bad.

3. Cash flow driven by stock options
The rise in accounts receivable took a $33 million bite out of operating cash flow. That hurt. On the positive side, "other current assets," which had been the problem in Q1, and payables improved, adding some $22 million back in. The result was that operating cash flow rose 86% sequentially, despite revenue and income gains of 17% each. That is what we want to see from eBay, where cash flow should surpass net income regularly.

Ah, but what about the tax benefit from stock options? I had complained in Q1 that too much of eBay's cash gain -- about 36% -- came from this tax benefit rather than from actual operations. It was a point on which I had a bit of an argument with management.

This quarter, eBay did something I've not seen before: In its earnings press release (which does not provide a cash flow statement), it said that cash flow from operations totaled $69 million, but that $21 million came from the tax benefit. It said that, therefore, "$48 million in cash was generated from general business operations."

Numbers aside, I was amazed. I have never seen the options benefit discussed so openly, with the admission that it does not represent well the ability of operations to produce cash. I give eBay's management huge props for its forthrightness and honesty.

And the numbers looked great. The options benefit now accounts for 30% of operating cash flow. Free cash flow (operating cash flow minus capital expenditures and the options benefit) rose 124% sequentially to $30 million, well above net income of $24 million.

Can the good times continue?
eBay had a great second quarter. It has naturally led people to question whether it can continue. Last quarter, I said, 'As things are, "the Street" is bound to start worrying about revenue growth soon.' Sure enough, TheStreet.com has lately begun to question eBay's growth plans. The central reason for the concern: slower growth in listings.

It's true that the rate of growth has slowed. That's natural as numbers get bigger. eBay has also explained that listing times have become shorter, because of Buy It Now and higher fees for longer auctions. Naturally, higher turnover means less listing "inventory." It can be seen in the numbers, too -- revenue per listing is 17% higher now than it was a year ago. Management's explanation is not only plausible, but it's also positive. It is much more in eBay's interest to make listing periods shorter.

Of course, growth rates will slow, growth expectations are big, and the stock price is accordingly high. eBay is on a pedestal, and it's windy up there. For my money, though, the second quarter demonstrated eBay's resilience to globally poor business conditions. There is room for it to improve -- which is good -- but it is already one of America's greatest companies. I'm betting it will stay on that pedestal for some time.

Brian Lund owns shares of eBay, but he's willing to trade them for a hand-made, full-size Vermont maple entertainment center and DirecTV. Bids? The Motley Fool is investors writing for investors.

Rule Breaker Portfolio


8/24/01 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AFFXAFFYMETRIX INC2.4510.95%24.82
AMGNAMGEN INC2.013.19%64.93
AMZNAMAZON.COM0.606.23%10.23
AOLAOL TIME WARNER INC1.734.32%41.81
CRAAPPLERA CORP - CELERA GENOMICS(0.01)(0.04%)27.35
EBAYEBAY INC3.957.17%59.01
HGSIHUMAN GENOME SCIENCES0.721.50%48.72
SBUXSTARBUCKS CORP(0.15)(0.80%)18.55

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(8/5/1994)
Annualized
Rule Breaker3.01%4.10%(5.45%)5.32%338.11%23.29%
S&P 5001.97%1.98%(2.17%)(10.25%)158.49%14.41%
S&P 500 (DA)1.86%1.87%(2.06%)(9.77%)172.75%15.28%
NASDAQ4.01%2.67%(5.44%)(22.41%)166.16%14.88%

Our overall return stats understate the portfolio's actual returns; here's why. See the internal rate of return below for an accurate statement of our annualized returns.

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (8/5/1994)
Rule Breaker29.88%
vs. S&P 50012.87%

Trade Date # Shares Ticker Cost/Share Price Total % Ret *
8/5/944020AOL0.4541.814858.55%
9/9/971320AMZN3.1810.23440.38%
12/16/981160AMGN21.4464.93202.78%
7/2/98940SBUX13.9818.5532.72%
2/26/991145EBAY46.5559.0126.78%
6/21/01(1150)AFFX21.6024.82(14.89%)
12/17/991260CRA39.7627.35(31.21%)
9/22/00560HGSI80.0548.72(39.14%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain *
8/5/944020AOL$1,816.44$168,076.20$238,852.20
12/16/981160AMGN$24,875.50$75,318.80$50,443.30
9/9/971320AMZN$4,204.20$13,503.60$48,810.50
2/26/991145EBAY$53,294.44$67,566.45$14,272.01
7/2/98940SBUX$13,138.62$17,437.00$4,298.38
6/21/01(1150)AFFX($24,843.50)($28,543.00)($3,699.50)
12/17/991260CRA$50,093.00$34,461.00($15,632.00)
9/22/00560HGSI$44,830.50$27,283.20($17,547.30)
 
Cash: 
Total: 
$37,361.92
$412,465.17
 

* 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.