Re: Ebay short

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By albaby1
October 19, 2001

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I was wondering why you decided to take a short interest in eBay, which seems to be chugging along fairly well business-wise, (but also seems to be absurdly overvalued) as opposed to something like Amazon, which, although some valuation argument may hold water, you know as well as anyone seems to be falling apart at the seams.

Here's my thinking on the short, both as to the fundamentals and the timing.

I. Fundamentals

Current prices require significant long term growth

Fundamentally, I believe that Ebay's price reflects an expectation of significant growth over a fairly long term. Put another way, I believe that Ebay needs to grow at an extremely high rate (more than 40% annually) simply to maintain its current share price in five years. That's consonant with Whitman's 50% per annum revenue growth projections � for an excellent analysis, I refer to TMFOrangeblood's FCF analysis from April 3 of this year:

TMFOB concluded that Ebay would have to grow by 57% per year to double its price five years out from a $30.69 close, assuming that the market was paying the same P/FCF of 38 that it was then-paying against the S&P500/Barra growth index. We're already at that double, and the market is presently paying only 29 times FCF � meaning that Ebay will have to grow FCF by significantly more than 57% per year, and will have to be more richly valued at the five-year termination than the growth index, just to stay at the same price as today. This translates into Ebay becoming the equivalent of nine (9) times its present size.

It is unlikely that Ebay can maintain that required growth rate in auction listings

We've talked about domestic auction counts continuously. Domestic auction count growth has generally been linear, so that even without this year's summer trough and recent tragedy, percentage annual growth has been continually falling. Where is it now? This Saturday, auction counts peaked at approximately 6.4 M auctions. The second Saturday of last October saw auctions peaking at about 5.35 M, which translates into year-over-year growth of less than 20%.

Ebay's historic growth has taken place during a time of incredible growth of the potential customer base � the unprecedented adoption of the Internet. During the last three years, domestic household Internet penetration essentially doubled from a 26.2% penetration rate to more than 50% penetration today:

Going forward, the prospects for background growth aren't as good, as domestic penetration shan't double again.

What about international auctions? One disturbing lesson from the domestic auction counts is the possibility that the hyper growth phase of the auction listing market only lasts about three years. The other significant factor to consider is demographics. Ebay has its own sites in a dozen countries: Austria, Australia, Canada, France, Germany, Ireland, Italy, Japan, Korea, New Zealand, Switzerland and the UK. Leaving out Japan, where Yahoo is the dominant auction site, the total population of those countries is approximately 382 M, compared to the United States' 284 M

Meaning that even if Ebay is able to continue the same dominance, the same growth in every one of those other countries as it has in the U.S., you have at best another one and a half Ebays of potential. Since Ebay needs to grow nine-fold to maintain current share prices, we have to look outside auction growth.

Real options have not yet materialized

Ebay has undertaken several efforts to generate meaningful revenue outside of its core auction business. Such potential lines of business have occasionally been referred to as "real options," as they are opportunities afforded the company by its unique market position that it may choose to exercise at its discretion. Significant exercised "real options" include real-world auctions (Butterfield's & Kruse), payment delivery systems (Billpoint), fixed-price sales (, fixed-price store hosting (storefronts), and advertisements. To date, only advertising has generated significant revenue for the company. Moreover, only advertising represented an organic growth opportunity � the other real options were acquired, meaning that Ebay had to exchange a part of the company for the real option value. These sidelights, together with other unexercised business opportunities, may be valuable but unlikely to provide the massive growth needed by Ebay going forward.

In short, I believe that Ebay's price reflects a unrealistic growth rate, and therefore reflects a fundamental long-term overvaluation.

II. Timing

Why now? For a few reasons, but mainly because Ebay has climbed back up to an attractive price for a short. The above analysis suggests that all of Ebay's long-term growth potential is already priced into the stock, meaning that natural volatility is likely to present an opportunity for a short position to be closed out at a profit.

That's the main reason � the market is offering a nice price. Yes, earnings season is upon us, and Ebay is set to announce in scant days. However, there's no particular reason to expect that Ebay will show a significant upward price move even on a positive earnings report � in fact, Ebay suffers a near-term drop following earnings more often than not. Buy the rumor, sell the news. There's nothing weird in the auction counts, either, other than what's been discussed above.

Sorry for the length of the post. Each of the above points is worthy of further discussion, and no doubt the worthy Ebay investors have excellent rebuttals in mind. Just wanted to explain in broad terms my thinking for the short.


P.S. Amazon scares me more than Ebay, precisely because the fundamentals are so much worse. I haven't the slightest idea what motivates an Amazon investor, so I have no idea what to expect going forward. With Amazon, you run the supreme risk that they will be able to establish "pro-forma operating profitability," with the concomitant risk that the Teeming Retail Investor Millions will flock into the stock. You run the risk of getting "inflected." Ebay might fly up during a rebound, but I don't see them having the same type of turning-point signal event on the horizon.


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