Wednesday, July 20, 2005

EBay's 2nd-qtr profit soars 53 percent - Yahoo! News

EBay's 2nd-qtr profit soars 53 percent - Yahoo! News Let me start by saying, eBay is the largest position in my personal portfolio. I hold it in such esteem because the market currently does not know how to value this company. How should the market value eBay? While one can analyze the current financial metrics in detail, the primary driver of eBay’s valuation is the “terminal value” approximation for the cash flows created beyond the two year time period forecasted by most analysts. Analysts depend upon comparables for approximating the terminal multiple. Unfortunately, there are few comparable business models to the unique nature of eBay’s business.

eBay’s unique combination of seller and buyer ratings create a high switching cost for the users of its liquid market place. Moreover, the barriers to entry continue to rise as the business expands—something reflected in its continuous rise in gross margin. The business is not capital intensive, so free cash flow margins are very high. eBay’s primary customers are consumers and small businesses. It not only controls the platform for its services (the market place), but it leverages that control to expand into other services like eBay Stores, PayPal and Finally, eBay is the undisputed leader of online auctions.

After listing these business model attributes, one might notice it sounds a lot like Microsoft. However, I have never seen anyone use Microsoft as a proxy for a comparable valuation analysis. Of course, this is in part due to the fact that Microsoft is at a very different point in its maturity relative to eBay. However, at some point in the past, Microsoft was the size of eBay. As such it might be instructive to consider Microsoft’s valuation multiples at the time to determine two things: 1) would the multiples square with eBay’s multiples today and 2) how accurately did the market forecast the long term cash flows that were ultimately realized. Following this line of reasoning, I found Microsoft generated strikingly similar financial performance from 1985 to 1993 (FY) relative to eBay’s 1997 through 2005. The revenue is nearly the same in absolute dollars during each of the last five years of this time series comparison.

One of the similarities in growth rates could be related to the similarities in the underlying customer base (consumers and small businesses) and the rate at which this market segment adopts technology. Another similarity could be attributed to the speed at which a standard spreads and the associated rents that a monopolistic provider can capture over time. Whatever the reason, the growth rates and absolute revenue numbers are very similar. It is notable that the analyst community has consistently underestimated eBay’s growth rate (the same can be said for Microsoft in the past). In both cases, the estimation error in forecasting could be attributed to the dependence upon “comparables” that were not really comparable. Comparing Microsoft’s growth to other software companies at the time would cause an analyst to consistently underestimate results. The same can be said of eBay when compared to other Internet companies.

The similarity in revenue leads to the next logical question—how do margins compare? To compare apples to apples, I’ve taken eBay’s margins from 1997 through 2005 and compared them to Microsoft’s margins from 1985 to 1993. Given the similarity in revenue during those respective time periods, comparing margins should be a fair exercise. If I knew how to post a chart I would, but suffice to say, these metrics are very close to each other near the end of the time series comparison.

Given the similarities in business models, it is not surprising that every element of the P&L between the two companies are similar. What’s is surprising, however, is that eBay’s gross margin has been higher than Microsoft’s for some time, and its other metrics are on track to meet or exceed as well. Is it possible that eBay could be a better business than Microsoft?

The sustainable monopoly position of Microsoft was not clear in 1991. Competitive offerings from IBM and even Apple kept the markets guessing as to who would win the war for standardizing the operating system. In contrast, most recognize that eBay has defeated Yahoo and Amazon’s efforts to create competitive online auctions. While Google has the potential to compete for some share of the small business online market, Google does not provide an auction marketplace that is competitive to eBay’s platform.

There are a few reasons to believe that eBay should trade at a premium to Microsoft now and in the future.

In the long run, eBay’s margins could be greater than Microsoft’s. For example, Microsoft will invests billions in R&D to develop the next generation operating system and technologies to extend into other markets like video games, voice recognition, and home entertainment. In contrast, eBay does not have to innovate its platform because the value comes not from the features offered by the platform, but the liquidity of the market place it supports. eBay investment dollars fund expansion into different markets like used cars or trading cards, but the expense required to develop the software for those markets is trivial relative to the cost of developing a new software application like Microsoft Office or Windows XP.

eBay’s revenue growth could exceed Microsoft’s in the long run. eBay’s revenue growth rises with the economic activity of its users since it charges on a per transaction basis. This model efficiently captures the consumer surplus created by the platform. In contrast, Microsoft fails to capture a significant amount of the consumer surplus it creates. As an example, the analyst who uses Excel every day to model a billion dollar portfolio pays the same price for the software as the student who uses Excel once a month to keep track of their MP3 music collection. Moreover, eBay has multiple sources of growth that do not require it to stray from it’s core platform and service, including international markets, verticals such as Motors, Sports and Consumer Electronics, category expansion, and extensions of PayPal. In 15 years eBay could be the global distribution environment for retailers and manufacturers.

While a case can be made for why eBay is the next Microsoft, there are plenty of counterpoints that highlight the risk of such as position. First, Microsoft benefited from several exogenous factors that had nothing to do with the merits of Microsoft’s model. In particular, the decision to base Windows upon an Intel platform looked smart in hindsight. However, they were fortunate that Intel outpaced IBM, Sun, and DEC to dominate the market for CPU’s. Second, the failures of Claris (WordPerfect), Lotus (123 spreadsheet), and Corel (Quattro spreadsheet) were due in part to Microsoft’s aggressive strategy, but each had their own idiosyncratic execution failures that collectively contributed to Microsoft’s dominance of the office application market in addition to the operating system market. It was only after the release of Windows 95 and the introduction of MS Office that the integration of the office applications with the operating system began to give Microsoft and unfair advantage. Both companies have strong management teams and aggressive cultures.

Only time will tell whether or not eBay will be the next Microsoft, but it is well positioned to achieve such a potential. The business has high barriers to entry, enjoying a virtual monopoly in its market. It delivers value to the consumer and small business market on a global basis. eBay enjoys extraordinary revenue growth and high margins with low capital requirements. Finally, it controls the proprietary platform that delivers its value directly to the customer without dependency upon distributors or other intermediaries.

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