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.

5 Comments:

  • Thanks for a most interesting read. Based on a few broker reports, I was under the impression the all-inclusive take rate for EBAY is closer to 10% rather than 15%.

    Also, it is true EBAY has never paid a dividend but they have already started a stock buyback program which is essentially the same and they are likely to continue this initiative going forward.

    As for you thesis, my only disagreement would be with your assessment of Skype. Yes, EBAY paid a lot of money for Skype and yes, it is a fast moving technology with high competition. But that does not take away from the additional value the company has as part of the EBAY family. In other words, Skype does not necessarily need to be the market leader to be worth $2.6 billion to EBAY if it can remove friction from deals and translate to higher GMV. I think that is the real question. Can Skype make it easier for EBAY sellers and buyers to transact? And that is something the marketplace will have to decide.

    By Blogger onlyebay, at 12 September, 2006 07:23  

  • Thanks for your insightgul post. And your blog is full of great ebay info. I will definitely make use of it in the future.

    For the type of auctions I list, they take a full 15%. But regardless of whether the overall rate is 10% or 15%, this is pretty extreme in the universe of commissions.

    A lot of companies have stock buyback programs, but historically ebay has overwhelmingly been a net issuer of shares. It will be interesting to see what changes occur and if ebay takes advantage of the pullback in its stock price to buy some shares.

    I agree that, hopefully, Skype will add value to the firm. But to me, as a value investor and Buffett disciplinarian, this is simply too far from certain to have any faith in a purchase price as outrageous as this. Much of my belief is based on my own experience. I just really don't see Skype contributing much at all to the transaction process on ebay. Perhaps, I hope, they will prove me wrong, but right now I am not convinced.

    By Blogger Andy Kern, at 12 September, 2006 17:34  

  • buffet has said that one bad acquisition can undo years of effort and accumulated networth. Thats what it seems to be with ebay. I don't recall buffett making a non-control purchase of a company/ business, where the moat was wide but management not great.
    Has buffett said anything,when you have found a great company with wide moat but management destroying value?

    By Blogger D P, at 15 September, 2006 19:34  

  • Really well done. Having also analyzed EBAY and stared, mouth agape, at the violence that the Skype deal did to the balance sheet, I couldn't agree with you more. In fact, find the Skype acquisition downright depressing. As a dedicated user and fan of EBAY's service, I want to invest but, because of Skype, simply cannot justify doing so.

    By Anonymous Anonymous, at 13 November, 2006 23:41  

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