Pundits of all stripes took notice last week when Rule Breaker holding eBay (Nasdaq: EBAY) announced better-than-expected earnings yet again. Amid earnings warnings from tech companies and failures of Internet companies with no business model, eBay provides a safe haven. It is a profitable, rapidly growing, online business.
But, it's not just that. I think that it is becoming more and more clear that eBay is a true rare bird: a company with great management, high profit margins, low capital expenditure requirements, and a huge moat around its business. This is an investment worthy of Warren Buffett or Philip Fisher. Take a look at it, guys.
Strong fourth quarter
Results for the fourth quarter were solid. Revenue came in ahead of our ambitious estimates, at $134 million. Gross margins of 82% were stronger than expected, leading to earnings per share (EPS) 50% above analysts' predictions. Operating margins came in at 20%, and net margins approached 18%. The company raised its revenue expectations for 2001 based on its acquisition of Internet Auction, Korea's largest auction site, and strong business momentum generally.
THE place to buy and sell online
It's possible for eBay to realize such strong margins because it has become THE place to buy and sell secondhand goods online. An auction site requires buyers and sellers. They feed off one another. Buyers need a wide selection of goods, sellers need competition to bring higher bids. The moat around eBay's business is the 22.5 million registered users and the 79 million items for sale. There is no reason for buyers or sellers to go elsewhere. In fact, one possible reason to do so recently disappeared, when Yahoo! (Nasdaq: YHOO) began charging a listing fee for its already underpopulated auctions.
Who now will challenge eBay in the secondhand market? It has already stared down competition from powerhouses Yahoo!, Microsoft (Nasdaq: MSFT), and Amazon.com (Nasdaq: AMZN), all of which launched auctions in 1998 or 1999. What more powerful competitors could build a trading community to compete with eBay? (Well, perhaps AOL Time Warner (NYSE: AOL), but it has bigger fish to fry.)
eBay will now work to diversify its revenue streams. Its fixed-price trading site, Half.com, now lists 10 million items, itself several times bigger than Yahoo! Auctions. eBay has also launched local sites for 60 cities and 8 different international sites. eBay Motors ranks third in the nation in used auto sales, behind AutoNation Inc. and the CarMax Group. If eBay can get a chunk of the used-car and classified markets -- even a small chunk -- revenues could skyrocket.
Is it overvalued?
The talking heads agree: This is a solid business. The only complaint one hears now is, "It's way overvalued." Ahh, music to a Rule Breaker's ears. Voyeurs among you might want to listen to Aram Fuchs on Yahoo! FinanceVision last week, who called eBay's valuation absurd. "It wasn't too long ago when a company earning $0.40 [projected EPS in 2001] would be selling around $8 or $10," he said, as though eBay were a mature tire manufacturer. Fuchs acknowledged that eBay is growing, "But we think [growth] will dramatically slow in about a year or two, now that just about everyone is online... [Eventually] the company will be valued mainly on earnings, not on this momentum."
How much would you bid?
I dare say that all companies are valued on future potential, not past earnings -- as the value axiom puts it, "A company is worth the discounted value of future cash flow." Cash flow, mind you, not earnings per share. eBay's cash flow from operations for the quarter was $0.12 per share, compared to $0.09 in EPS. For the year, it had $0.35 per share in operating cash flow and $0.19 per share in free cash flow (assuming about $10 million in capital expenditures last quarter, which is about what the balance sheet indicates).
High expenditures in Q1 2000 make the trailing free cash flow number considerably lower than it will be next quarter. If eBay merely replicates in Q1 2001 its average free cash flow over the last three quarters, trailing free cash flow will come to $0.30 per share. Let's take a shot at discounting its future cash flow from there.
One possible value
Management, which is known as conservative in its guidance, said in September that it anticipated $3 billion in revenue by 2005, a 50% annual growth rate. That's ambitious, to be sure. Let's reckon 40% annual free cash flow growth over the next five years, 25% over the following five years, 15% over the next decade, and 7.5% thereafter.
At a discount rate of 11% (the average return of the stock market), we get an implied terminal price-to-earnings ratio of 28.6. Assuming 2% share dilution annually (dilution was 1.6% last year) in the first decade and 1% thereafter, we get a present value per share of... $83.62. There you go. That's the price. Go forth and prosper.
Just kidding. Of course, that number is a fiction. (For those who would like to see the numbers laid out anyway, I've posted them on the eBay discussion board.) I think that it will, in fact, turn out to be far wrong -- either way too high or way too low. I'll point out, though, that, all other numbers being the same, the market is valuing eBay at about 32% five-year growth and 20% growth in the following five years.
Of course, that whole exercise is loaded with variables that, if tweaked, would change the result dramatically. Mr. Fuchs would surely say that my growth rates are ridiculous, "Now that just about everyone is online." I would respond that my numbers are no more ridiculous than attaching a 20 P/E ratio to eBay and calling it overvalued. On the contrary, my numbers could well be too conservative, but Fuchs' methodology -- at least as far as he has described it -- is certainly misguided.
We think that eBay has an enormous market opportunity in collectibles, CDs, books, used cars -- you name it. We think it has a trading platform and community that provides it with many further possible revenue streams. We think that it won't even occur to the next generation of Americans (or Japanese or Britons or Germans) to sell stuff in garage sales or at the local secondhand store. They'll just sell it on eBay.
Jeff Fischer wrote yesterday that eBay was his favorite long-term holding. I second that. More than any other company I own, I think that eBay has a strong, sustainable advantage and huge growth opportunities. I'm with it for the long haul as well.
I wonder when Mr. Buffett will join us at shareholder meetings.