Berkshire Ruminations

Sunday, September 10, 2006

A look at ebay - Part 2

Ebay simply has one of the best business models imaginable. They have no inventory, yet they sell billions of dollars worth of merchandise every year. You can think of the company as a broker for just about every type of consumer good there is. A broker that takes a hefty 15% commission on each transaction. And because of the networking effect I discussed in Part 1, they are the broker that people around the world go to when they want to buy and sell stuff. There is no real limit, as I see it, to how much stuff they are capable of selling, so I do not think it is completely unreasonable to assume the company can continue to grow at some pretty remarkable rates.

What do I mean by remarkable rates of growth? Well, in 2005, 2004 and 2003, net income grew by 39%, 77% and 76% respectively. Revenue growth was comparable, at 39%, 51% and 78%. These numbers are phenomenal. All the while, profit margins have remained strong. Since 2000, the company seems to have focused on this. It made an important, and very wise, acquisition when it bought Paypal in 2002. In contrast to other acquisitions the company has made (to be discussed momentarily), Paypal not only yielded natural synergies with the flagship website, but was also a great, profitable company in its own right. Net margins got a nice boost from this acquisition, jumping from around 10% in 2001 to the current level of around 23%.

Despite the amazing growth in sales and income, ROE and ROIC have not budged, staying around 12% since 2000. Ebay has never paid a dividend, and rarely has assumed debt, so much of this invariability is due to the company’s retained earnings balance which has mushroomed along with earnings. But another big part of this phenomenon is the company’s continued issuance of new equity, whether it be the result of option exercise or SEOs. Indeed, the company’s paid in capital account has risen faster than retained earnings in every one of the last five years. So although the company is indeed growing by just about every measure, it has never become more productive. But 12% is not awful either, so as long as earnings keep going up, I suppose this is a pretty good indicator.

In general I would say that Ebay’s fundamentals seem consistent with the franchise value and competitive analysis I wrote about in Part 1. But one huge exception to the strength of Ebay’s franchise results from the acquisition the company made in 2005 of Skype Technologies, S.A. Skype is a voice-over-internet protocol provider, similar to its chief competitor, Vonage. After first hearing about this acquisition, I had a suspicion that it was a bad move.

As I have shown, Ebay has enormous brand value. But Skype operates in an industry where brand value does not go nearly as far. While the company is indeed a leader, I see no compelling reason to believe it must continue to be. The industry has very low barriers to entry, its technology is fast-changing and could potentially be supplanted by a superior technology in the future. More importantly, though, it provides a commodity-like service. Purchasers of VoIP, especially as the industry matures and new entrants enter the market, base their purchase decision in large part on price. This is a recipe for low returns, and something the individual investor should simply avoid were it a stand-alone company.

I find it telling that throughout Ebay’s 2005 annual report, management makes reference to all of the great operational ways Skype will help Ebay’s traditional operations, although management avoids ever using the word “synergies,” but fails to ever brag about what Skype will contribute to the company’s bottom line, profit margins or ROE. So let us take a closer look at what happened last fall.

Skype was purchased in October 2005 for about $2.6 billion (that is not a typo – that is billion with a “b.”) of which an amazing $2.3 billion was booked as goodwill. The remaining $300 million accounted for Skype’s tangible assets. Does a price-to-book ratio of 8.6 sound high to you? It did to me, so I did a little more investigation to put this number in to context.

For starters, the $2.6 billion is an understatement of the true cost, as Ebay also assumed obligations to pay nearly $1.3 billion in incentives to Skype executives should they meet certain targets. That is a lot of money, since at the time of the acquisition, Skype had never turned a profit. It is estimated, though, that Skype brought in $60 million in revenue 2005. (After the acquisition, of course, Skype’s revenues were consolidated with Ebay’s so it is difficult to tell exactly how much the company sold. But it wasn’t much.) That $60 million in earnings puts the purchase price at a beefy price-to-sales multiple of 65.

More importantly, though $2.6 or $3.9 billion is simply a lot of money for Ebay, which had balance sheet totals at the end of FY2004 of only $8 billion. So in essence, Ebay, the company with the dreamy business model and an iron-clad-alligator-infested moat, is wagering nearly half of its net worth on the future of Skype, which I believe to be very uncertain. This is downright foolishness in my opinion.

As always, any and all comments are welcome.

Saturday, September 09, 2006

MIZZOU alumni magazine reaction

In the recently published Fall 2006 issue of MIZZOU, the University of Missouri's alumni magazine, there appeared an article about my class, and to some extent, about me. The article was written by Catherine Pernot, and is similar to the article that she wrote for the Columbia Missourian earlier this year.

I anticipated some type of reaction, but beyond phone calls and emails from old friends, the reaction to the article was muted. The editor of the magazine did pass along a letter written to her by an alumnus of the journalism school. I repsonded to the letter only for my own benefit and for this blog, so as far as I can tell, the Reader will never see it. Below, find my summary of the Reader's letter, and then my reaction to it.

Reader writes (paraphrased by me):

Students of MU are ill-served by FIN 8001, the Warren Buffett Class. The material in the course contradicts our best understanding of the markets and even what Mr. Buffett suggests. Mr. Buffett suggests investing in index funds, therefore supporting the efficiency of the markets. I am dismayed that students enjoy "abandoning the academic ideas of efficient markets" and that the author of the article says "Markets are not efficient, financial diversity is for dummies..." Mr. Buffett's recommendation of index funds for individual investors shows that he thinks diversification is better than concentrating on a small number of stocks. Finally, I hope MU's medical school is not as dumb as the business school is to "abandon the academic ideas."

And My Response:

I can appreciate Reader’s reaction, as the article did indeed have a fairly antagonistic tone. And as he is an employee of an “academically-based” investment firm, I can understand his reluctance to embrace the benefits of our course. However, I think his understanding of the course is too superficial to knowledgably rebut it. I would submit the following to him in response.

Our course indeed acknowledges the merits of Efficient Market Theory (EMT), but also its shortcomings. I think Reader misinterprets the word “abandon” in the student quote to which he refers, “It was great to have a class on investing that more or less abandoned the academic ideas of efficient markets....” The course does not disregard EMT, but rather ignores it in favor of alternative explanations for business valuations. Such an approach is crucial to teaching the fundamentals of finding enterprise value – a skill that is highly transferable to a variety of areas in finance and financial services. That is, if EMT held, and firms trade at their intrinsic value, who would concern himself with determining what that intrinsic value is? Instead of dismay, I would hope Reader feels comfort that MU students are working to gain a skill set that many students at other universities graduate without.

I feel the following quote from Mr. Buffett’s 1988 letter to shareholders is very consistent with the perspective of FIN 8001.

"Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day."

Warren Buffett does indeed encourage individual investors to invest through index mutual funds, but not because of the efficiency of the market as this Reader asserts. Rather, he sees diversification as an effective way for an individual, relatively ignorant about business and its valuation, to take part in the economic productivity of business. Diversification is protection against ignorance, he maintains, but those who are not ignorant have no need to diversify. When an individual does diversify, index funds are the best way to do this because they minimize costs that commonly eat away at actively-managed fund returns.

Perhaps the following quote from Mr. Buffett's 1993 Annual Report will help Reader understand Buffett's position as well as the author’s commentary that “financial diversity is for dummies.”

“Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

“On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”

I would also submit that mutual funds’ general failure to outperform the market is not a result of fear and greed, but rather the often excessive fee structures that they employ. Reader, being a beneficiary of such a fee structure, though, would likely rather ignore this factor.

The academic process is founded in curiosity and is only advanced through a constant questioning of accepted doctrine. If ever there were a place in business education to introduce an alternative explanation, I believe efficient market theory is it given the long history of anomalies and critiques that have been documented and published since Eugene Fama’s original paper in 1970. The recent literature clearly supports this attitude, in my opinion.

I am disappointed that Reader focuses on the course’s “dismissal” of semi-strong form EMT but only makes passing reference to the ideas derived from a different academic theory, behavioral finance, which is discussed in the course and mentioned in the article. It is for this reason that I find his analogy to the medical school “abandoning the academic ideas” not only scurrilous, but unfounded.

Finally, as an academic myself, I wholeheartedly appreciate Reader's objection. However, I think both his perspective on academic finance and on this course is too narrow.