E-commerce giant eBay (NASDAQ:EBAY) is spending more to grow its business. This makes sense, of course, since the company has a very valuable asset in the form of its PayPal payment business, which eBay will soon spin off as a stand-alone entity. In preparation for letting PayPal loose, eBay spent more money to build the business as much as possible. The results are now bearing fruit, as PayPal is sufficiently large and successful to survive on its own. By pursuing the spinoff, eBay will unlock significant value for shareholders.
That's because PayPal isn't getting proper credit for its growth, since eBay as a whole trades for a modest valuation. From the company's perspective, the independent businesses can garner a higher combined valuation than the single entity that exists now. All this means that eBay's billions in capital spending was money well spent.
PayPal is leaving the nest
Over the first nine months of the year, eBay allocated $902 million to capital expenditures, and it is on pace to eclipse the $1 billion the company spent on capital projects in 2013. Much of this was to expand into new markets and in mobile, and to build up the PayPal brand, which is the best-performing aspect of eBay's business by far.
eBay as a whole is posting solid growth, meaning it has created value from its investments. Revenue grew by 12% through the first three quarters of the year, to $12.9 billion. Operating profit was up 4% over the same period. Not surprisingly, PayPal has done the heavy lifting, with its revenue growing by 25% last quarter, and now accounts for approximately 45% of eBay's total revenue. One of eBay's other core businesses, marketplaces, is actually struggling somewhat. Slowing growth in the segment was the primary reason eBay warned investors it expects full-year earnings results to come in at the lower end of its guidance.
Last quarter, sales and marketing expenses as a percentage of revenue increased almost 2 percentage points year over year, to 20.2%. Capital expenditures as a percentage of revenue also increased by 2 percentage points in the same period. While eBay's higher spending might give investors pause, the rewards of that outlay are there. PayPal is a strong platform and has now gained a solid foothold in mobile. It is on track to process 1 billion mobile transactions this year and gained more than 4 million new active accounts just last quarter.
PayPal should derive a higher valuation
As it stands, eBay holds a fairly modest valuation. The stock trades for 15 times forward earnings estimates, which is about on par with the valuation of the broader stock market. This seems to be a significant discount to where eBay should trade, considering eBay's above-average growth potential.
eBay has been weighed down by some difficult headline news, including the highly publicized data breach earlier this year that has served to damage eBay's brand. Meanwhile, PayPal keeps growing at high rates. When it trades on its own, it's very likely it will garner a higher valuation from investors. That's how management envisions the spin-off creating value for shareholders.
New opportunities abound
eBay's capital expenditures also significantly aided the company's penetration into new markets. One example is eBay's $50 million investment last year in Snapdeal.com, India's largest online marketplace. At the time, the investment was made as a means to gain access to 20 million registered users in one of premier emerging markets in the world. Judging by eBay's success internationally, it seems that these investments are starting to bear fruit.
Growth in international regions is outpacing growth in more developed economies such as North America. For example, eBay's revenue from the United States increased 9% last quarter, while revenue from international markets increased 14%. In fact, eBay now gets more than half of its revenue from outside the United States.
The spinoff makes each company more agile and focused. This will allow both companies to accelerate their positions in the rapidly growing areas of e-commerce, particularly payments. There is an emerging opportunity now that payments are increasingly becoming digital. Smartphones could essentially be a replacement for wallets one day, allowing individuals to pay for everything straight from their handset without having to carry cash or credit cards. PayPal is perfectly situated to benefit from this, as it has a strong brand and is seeing accelerating volume growth.
Thoughts on the Internet seller
With economic growth looking shaky in several areas of the world, it might seem like a red flag for a company to accelerate its capital expenditures. But eBay is in a unique position. It has a prized asset that it is about to spin off into a separate company. In preparation for this, it was key for eBay to build up PayPal and its remaining business to the point where each could operate independently.
eBay has successfully done that. Overall revenue and profits are growing and PayPal itself is doing very well. It is gaining traction in mobile and in digital payments, and also making headway in international markets to capitalize on the higher growth potential of emerging regions. For all these reasons, investors should not worry about eBay's increasing capital expenditures.