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Analyzing eBay

Thursday - 4/18/2013, 2:47pm  ET

eBay  is the premier online commerce company. Individuals and businesses can list items for auction or at “Buy It Now” prices, and consumers buy the products, sometimes brand new and other times in used condition. It's a very simple and easy to understand business, as every time a seller lists a product, eBay gets to charge a transaction fee. With 112 million active users and more than 350 million listings globally, eBay is a solid company.

Competitive advantage

eBay has a huge competitive advantage because of its network effect, meaning that because so many people use eBay, other companies can't really compete. If someone wants to find a product, they generally search Amazon.com , maybe Craigslist, and eBay.

Other e-commerce plays have a tough time competing with eBay. For instance, there must be a link between two people in order for the business to work (a buyer and a seller), and it’s almost impossible to establish such a network when eBay’s business already works seamlessly.

Even if I had $1 billion, I couldn’t compete with eBay. That's because the company's advantage isn’t measured in monetary terms but instead in people, and it’s that trust and loyalty that gives eBay a huge moat.

Amazon’s model is more of a store front, much like Wal-Mart . The difference between Amazon, Wal-Mart, and eBay is that eBay doesn't actually sell anything, whereas the other two do.

In addition, Amazon and Wal-Mart sell significantly fewer products than eBay (think of the items and services sold by individual people that aren't sold in stores.) Although Amazon and Wal-Mart are tough competitors, they can’t match eBay’s advantage of connecting two people for a transaction.

Growth opportunities

eBay has a lot of opportunities to grow. First, with an already superior network, more people looking to sell and buy products will use eBay to gain access to millions of others who are similarly looking to buy or sell said products. With more people using eBay, this means more listings and more revenue for eBay.

In addition, eBay’s PayPal service is growing in the mobile arena, allowing consumers to pay just by entering an email and password, or via Near Field Communication (NFC) technology found on some newer phones.

eBay gets a small cut when a transaction is made through PayPal. With the rise of eBay’s network effect and mobile payments, eBay still has plenty of room to grow.

Management

eBay has a great management team. Pierre Omidyar founded the company in 1995 and has been chairman since its incorporation. He also owns 121 million shares, or 9.4% of the company, and is eBay's largest shareholder.

It’s always great to see a company’s founder still at the helm -- especially as the largest shareholder. With Pierre having much of his future tied to eBay’s performance, he’ll ensure the company matures well over time.

eBay’s CEO is John Donahoe, who owns about 400,000 shares as well as 2.8 million options that expire in May. Donahoe has been CEO for about five years and earns just under $1 million in base salary. When you add in a $2.8 million bonus and millions of dollars more in stock grants, his total compensation comes out to $29.7 million.

If that makes you cringe, know that 70% of his total compensation is tied to his performance (and since the company did well last year his pay is somewhat higher than usual).

I find that his huge paycheck is reasonable because if the company starts to decline, so will his bonus, and I am perfectly fine with that. Shares outstanding have been consistent at 1.3 billion, and while the company hasn’t repurchased any shares, it also hasn't been diluting shareholders' positions.

Financial analysis

To recap before heading into the numbers, eBay has a wide moat with many growth opportunities and has a management team that is heavily invested in the success of the company. As a result, I believe that eBay can be a great investment. Let’s look at the numbers to see just how awesome eBay is.

  • Since 2008, eBay’s sales have increased 64% and net income has increased by 46%.
  • The cost of goods sold has stayed the same at around 30% of sales. This means that costs aren’t increasing but they’re not decreasing, either, so eBay can’t squeeze profits by cutting costs. It will have to rely on selling more instead of cutting costs.
  • Net margins have approximately been in the mid-20% range for the past couple of years, which is more than double the industry average.
  • Return on invested capital is around 14% for the past five years
  • Equity (or book value) has been increasing around 16% for the past five years
  • Cash flow from operations has been increasing every year, with a 7% increase from four years ago and a 17% increase from last year.
  • Free cash flow has also been increasing, growing 3% from four years ago to 12% last year.
  • Free cash flow/sales decreased 22% four years ago and fell 18% last year. With such a high FCF/sales rate, however, the decline shouldn’t cause investors to shy away. If eBay was reporting 5% FCF/sales and it was decreasing, then I’d start to get nervous. But with 20% of every dollar turning into free cash, I’m content with that.
  • The return on equity averages to 16% for the past five years, about 3% above the industry average.
  • Return on assets averages to 11% for the past five years, meaning for every dollar of assets eBay returns 11% on average as net income.
  • eBay has $4.1 billion in long-term debt, which can be paid off using free cash flow in two years (if it had to). eBay’s debt-to-equity ratio is 0.2, which is reasonable. Although I like companies that have very little or no debt, eBay does a responsible job of managing its debt, and can pay it off if it had to.
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