At Motley Fool Stock Advisor we're about finding stocks with huge long-term upside. Our research efforts double-down on a company's growth potential, competitive advantage, and management quality. It's a strategy that has led to a total average return of 60% for our stocks and 14% annualized returns since inception versus 1% for the S&P 500.
Let's see why eBay (Nasdaq: EBAY) currently makes our buy list.
Growth potential
EBay's long-term growth potential lies solely on PayPal -- its fast-growing electronic payment processing business. In PayPal's early days, eBay was the growth engine while PayPal was simply an alternative payment method. A decade later, eBay's auction site is struggling to muster growth while PayPal has its foot firmly on the gas. PayPal provides secure online transactions for all kinds of purchases, and despite the recession, it has grown its top line 20% a year since 2007.
PayPal added 1 million new accounts each month during the second quarter. PayPal has moved beyond its eBay borders with about 60% of total payment volume coming from other merchants. Revenue for this off-eBay merchant business has grown 40% for three consecutive quarters. Much of the growth has come from abroad.
PayPal is growing 50% faster abroad than in the U.S., and more importantly, is spreading its brand in a huge market. The largest growth opportunity lies in Asia where the most developed online retail markets are Japan and South Korea. PayPal recently landed a deal with Softbank in Japan, gaining access to a $25 billion e-commerce market and acquired Gmarket last year, South Korea's largest online retailer.
The largest opportunity in Asia is obviously in China and its emerging market neighbors. China's largest online retailer, Alibaba Group, has trounced eBay's online retail attempts in the country. So it was a surprise when Alibaba recently added PayPal as a payment option on its online business-to-business site Ali Express. Ali Express connects merchants outside of China with suppliers within the country. While this deal may not provide access to China's large and growing consumer base, its recent deal with China UnionPay just may. China UnionPay is a fast-growing bank card company in China with 2.1 billion cards issued. PayPal will now be an option for CUP card holders when making purchases online.
In the near term, growth may be muted by what eBay CFO Bob Swan called a "dramatic slowdown" in cross-border trade among the U.S., Europe, and Asia in last week's conference call. The second half of the year may be less than spectacular, but over the next several years we expect PayPal to continue its double-digit growth rates. Online retail in developed markets outside of the U.S., especially in Europe, should continue to grow. And at eBay's current stock price -- 11 times earnings and 12 times free cash flow -- we are buying a stock without much growth priced in.
Competitive advantage
Historically, eBay has benefited from a very strong network effect where each additional buyer attracted additional sellers and vice versa. But in the U.S., the online retail market has drifted away from the auction format while simultaneously expanding because of the Internet's low barriers to entry. As online retail expands, eBay faces intense online competition from the likes of Amazon.com (Nasdaq: AMZN) and big-box retailer Wal-Mart's (NYSE: WMT) Internet site. Internet search giants Google (Nasdaq: GOOG) and Yahoo! (Nasdaq: YHOO) also function as shopping portals that direct users to stores, similar to eBay.
In terms of competitive advantage, the torch has been passed to PayPal, where its network effects are still strengthening because of its global expansion and growing brand recognition. More than 75 percent of eBay purchases in the U.S. are done with PayPal, and more than half of the largest merchants in the U.S. offer PayPal -- more than double the ratio of any other country. PayPal also benefits from higher barriers to entry than eBay's retail sites because of various government regulations for payment processors. Just ask global money mover Western Union (NYSE: WU), which staffs 400 employees and spends about $40 million a year just on regulatory compliance.
While you can count on PayPal's growth in the U.S. and Europe, where its share of online transactions is still less than 15%, growth in China may be much more difficult. Strict government oversight, virtually no brand recognition, and an established direct competitor in Alibaba's Ali Pay will be tough to overcome.
Management
Longtime CEO Meg Whitman stepped down in 2008, leaving the task of reviving a struggling online retail business to new CEO John Donahoe. Donahoe has run the retail business for about five years now and is attempting to change consumers' perception of the auction site with a greater emphasis on fixed-price shopping. Donahoe first tested the strategic shift in the U.K. and Germany and has had success. In the second quarter, strong retail sales in Europe were a bright spot, helping the company beat analyst estimates.
Chairman and founder Pierre Omidyar owns about 12% of the company while Donahoe owns less than 1%. We think management is properly aligned with shareholders' interest. The major concern for shareholders is how management spends its near $5 billion in cash. Historically, management has had its ups and downs with acquisitions -- PayPal was a huge hit while Skype was a bit of a mess. We hope management focuses on repairing its online retail business while growing PayPal and building its competitive advantage.
To get our exclusive content on eBay and access to our updated buy, sell, and hold recommendations on all 90 companies on the Stock Advisor scorecard, take a free trial of Stock Advisor. In the meantime, let us know what you think of eBay in the comment section below. Does it make your buy list?
