eBay (Nasdaq: EBAY) at its current price represents one of the trickiest conundrums an investor can face: a wonderful company with a pricey stock. Rule Maker investors in particular are likely to run into this situation. No company becomes a Rule Maker without attracting plenty of investor love. So, today, I'm going to do my best to unpack eBay's valuation and consider whether the stock is currently attractive.
This article actually picks up where we left off two weeks ago when I put forth five reasons why I admire eBay's business, which I'll quickly recap:
- The ultimate sustainable competitive advantage: network effects.
- The ideal combination of a high-profit, lightweight software business and a durable consumer franchise.
- Global business with no cultural barriers.
- Synthetic low-cost provider advantage.
- Management's emphasis on convenience initiatives.
There are many other attractive elements to eBay's business -- strong partnerships, seasoned management, and an awesome brand, just to name a few -- but the above five are my favorites. I concluded my earlier article by promising an assessment of eBay's valuation. Here we are only two weeks later and the stock is already 15% higher, so I better get moving on my valuation analysis!
Yesterday, eBay's stock closed at $53.14, giving the company a diluted market capitalization of $14.8 billion. That's 34 times fiscal 2000 sales of $430.7 million and 294 times fiscal 2000 free cash flow of $50.4 million. No, the stock is in no way cheap by any traditional definition, but as with all equities, what matters is comparing the current price to future results. And this is a company with an unquestionably bright future. It's only a question of how bright.
Stripped down to its simplest level, there are three major moving parts in our valuation assessment: revenue growth, future Cash King Margin, and future price-to-free cash flow multiple. We'll tackle these one by one.
eBay management has been quite vocal in its prediction of $3 billion in annual revenue by 2005. This will require a massive amount of gross merchandise sales (GMS), which are the value of goods bought and sold on eBay's network. Historically, eBay has captured eight cents in revenue per each dollar of GMS. Based on this ratio of revenue-to-GMS, let's walk through the numbers and see if we can back our way into management's revenue projection so that we can understand some of the assumptions being made.
Last year, GMS totaled $5.5 billion, which management estimates represented only 0.46% penetration of the $1.6 trillion global addressable market for goods that could be sold online. By 2005, eBay management has a goal of capturing 1.5-2.0% of this market, which by then should total $2 trillion. If successful, eBay would take in $30-$40 billion in 2005 GMS. By multiplying total GMS by 0.08 (revenue-to-GMS ratio), we see that 2005 revenue might range somewhere from $2.4 billion to $3.2 billion.
Based on the fact that this revenue range is largely below management's $3 billion target, it appears likely that eBay will increase its listing and selling fees. eBay has already, back in January, demonstrated its ability to increase its fees. Such pricing power is a classic profit lever of the most dominant Rule Makers. No doubt eBay's managers are familiar with how Walt Disney (NYSE: DIS), during the 1980s, was able to successfully increase the price of admission to its theme parks from $18 in 1984 to $28 by 1988 without any public outcry -- because prices were increased gradually, in increments under 10%.
But even with the awesome power to carefully increase its prices, eBay still must capture approximately $35 billion in GMS by 2005, representing 45% annual growth. Is that feasible? Well, consider that in the first quarter of this year, GMS grew 72% year-over-year. Also consider the following growth drivers, already in place:
- International expansion (soon to have 18 country-specific eBay sites)
- Rapid sign-on of business sellers (including Sun Microsystems, Disney, Ritz Camera, and even the U.S. Postal Service)
- Convenience initiatives that make it easier to use eBay (e.g., Billpoint email payment service, "Buy It Now" option to buy immediately, Shipping Education Center, and fixed-priced trading via Half.com
- Growing consumer acceptance of eBay as a safe, fun, and economical place to shop
While I can't even begin to validate eBay management's estimate of a $2 trillion global addressable market by 2005, I can see that the pieces are in place to drive GMS growth upward, and therefore I'm inclined to trust management's $3 billion revenue forecast. Based on your understanding of the facts, you may be inclined to discount (or possibly inflate) that estimate.
Future Cash King Margin
With a grasp of what future revenues might look like, the next step is to figure out how much of those revenues will be converted into cash profits, or what we call free cash flow. By definition, then, the number we want to project is the future Cash King Margin (CKM), or free cash flow as a percentage of revenue. In fiscal 2000, eBay's $50.4 million in free cash flow on $430.7 million in revenue translated to a CKM of 11.7%. Expect that number to increase steadily in the years ahead as eBay grows sales faster than all other expenses and capital expenditures.
In many ways, eBay is like a software model in that it has mostly fixed costs: the technology infrastructure, the essential support staff, the necessary brand marketing and promotion -- these costs don't rise proportionally to the number of transactions on eBay's network. Rather, these costs are fixed, and when revenue surpasses fixed costs, each incremental dollar of revenue falls straight to the bottom line. This is sometimes called operating leverage.
Because of the inherent leverage within the eBay model, it's not surprising that eBay management projects a long-term operating margin (pre-tax) of 30-35%. Based on this level of pre-tax profitability, it seems reasonable to me that the company will be able to generate a 20% Cash King Margin. This is a ballpark estimate, but if anything, this is a conservative assumption. From Q2 to Q4 last year, eBay's CKM was 17.8%, so we're not talking about a big stretch to reach 20%.
Given a 20% Cash King Margin applied to $3 billion in fiscal 2005 revenues, eBay would earn $600 million in free cash flow that year.
Future price-to-free cash flow multiple
As mentioned earlier, eBay is currently trading for 294 times its fiscal 2000 free cash flow. While seemingly high, it's important to remember that when evaluating companies in hypergrowth, all valuation rules of thumb (i.e., "never buy a growth stock with a multiple over 30") must be set aside. It's more useful to look ahead and consider that eBay is currently trading for 24.7 times our projected 2005 free cash flow of $600 million.
What we really need to consider, however, is the price-to-free cash flow (P/FCF) multiple eBay's shares might fetch five years from now. If eBay delivers on the growth scenario I've laid out, it will be growing revenues by 50% annually and free cash flow by 64% annually. High growth, high margins, and high barriers to entry all support the case for a premium multiple. As I made a case for two weeks ago, eBay's business combines the attractive elements of a software company (advantage: scalability) and a branded consumer goods company (advantage: predictability), both of which typically carry premium multiples, even if only growing revenues modestly.
By 2006, I would expect eBay to carry a P/FCF multiple between 40 and 50, based upon continued high- growth prospects, the strength of its business position, and the predictability of its revenue model. (By way of comparison, the S&P 500 currently trades for 24 times FCF, and Coca-Cola (NYSE: KO) trades for 40 times FCF.) Here's how eBay's future market cap could vary based upon this range of P/FCF multiples (given $600 million in 2005 free cash flow):
P/FCF 2006 Estimated Market Cap 40 $24 billion 45 $27 billion 50 $30 billion
Again, eBay currently carries a market cap of $14.8 billion, so in order to achieve our Rule Maker goal of doubling in five years (2x/5y), eBay would need to deliver on all the growth and profitability expectations outlined in this article and be granted a generous multiple of close to 50 times free cash flow.
Nowhere in this analysis have I allowed much of a margin of safety in any of my assumptions, other than perhaps within the Cash King Margin, which could perhaps go higher than 20%. Buying eBay at a market cap closer to $12 billion, or $43 per share, would more comfortably allow for the likelihood of doubling your money in the next five years. Currently, eBay stock is hot to trot and has lots of optimism swirling about its stature as "the lone survivor among the dot-coms." A Rule Maker investor with a long-term perspective will generally do better to acquire shares of great companies when the consensus is a bit less cheery.
But as I concluded in my last article, eBay is the premier emerging Rule Maker, and investors would do well to follow the company's progress.
Matt Richey is co-manager of the Rule Maker Portfolio and owns shares of eBay. Matt is currently battling fellow co-managers Zeke Ashton and Todd Lebor in daily cutthroat matches of ping pong. Matt is beating Zeke pretty consistently, but Todd is playing him pretty tough. The Motley Fool is investors writing for investors.