eBay Seems Undervalued, But Wall Street Will Need Convincing

By Stephen D. Simpson, CFA | July 18, 2013 AAA

It has to be a source of frustration to some investors that Amazon (Nasdaq:AMZN) can basically ignore margins and cash flow and get away with it, while eBay (Nasdaq:EBAY) delivers double-digit returns on invested capital and ample free cash flow and doesn't seem to get the same love. Given that the company is likely looking at years of ongoing investments to grow its payments business, that may not change right away. Even so, eBay looks like an underrated cash flow generator, with ample balance sheet flexibility to make additional strategic moves and/or return cash to shareholders.

Reasonable Results, But It's Never About Today
eBay delivered a pretty respectable set of numbers for the second quarter. But as is so often the case, the near-term outlook outweighs the recent results and long-term prospects when it comes to the stock market reaction.

Revenue rose 14% this quarter, or about 15% on an organic basis. Marketplaces revenue rose 10% (slightly more than half of total revenue), GSI commerce revenue rose 11%, and payments revenue rose 20%. Margins were so-so – not so great in an absolute sense, but in line with expectation. Gross margin declined about two points from last year, while operating income rose 8% (with a two-point drop in operating margin).

SEE: A Look At Corporate Profit Margins

The Details Look Pretty Reasonable As Well
Looking below the headline financials, it seems like the basic metrics of eBay's business continue to come in pretty good. Marketplace users rose about 14%, and the company is still in the early days of the Cassini search engine launch. PayPal active accounts rose 17%, and total TPV rose 24% for the quarter, with 29% growth in “off-eBay” TPV (to almost $30 billion) and 15% growth in “on-eBay” (to $13 billion).

Soft Guidance Now The Story
While the second quarter results looked fine, eBay managed buried that with guidance that is taking full-year 2013 performance to the low end of the range. None of the named issues – currency headwinds, economic weakness in Europe, and weakness in Korea – are exactly surprising, nor likely to endure for the long-term, but tech investing is a particularly “what have you done for me lately” sort of sector.

Payments Is Going To Take Time And Money
eBay has made it clear that they are going to do what it takes to make PayPal a viable POS alternative in the off-line “bricks and mortar” retailing world. Well-known retailers like Home Depot (NYSE:HD) and Foot Locker (NYSE:FL) are already on board, but usage is still running fairly low.

SEE: 3 Strategies To Profit From Earnings Season

At the same time, there's still a shakeout occurring in physical terminals as traditional players like VeriFone (NYSE:PAY) and Ingenico try to keep what they have, while newcomers like Square, Intuit (Nasdaq:INTU), and Google (Nasdaq:GOOG) muddy the waters with alternative approaches for in-store, mobile, and online payments. Last and not least, there's still a fairly constant drumbeat of expectations that Apple (Nasdaq:AAPL) will eventually jump into the payments fray.

What this all means to me is that it's still anybody's guess as to what the future payments world is going to look like. I think PayPal will be hard to unseat in the online world, but it's going to take significant investments to shift business away from VeriFone and Ingenico, to say nothing of fending off Square and other newcomers.

The Bottom Line
eBay's returns on capital and free cash flow production (as a percentage of sales) are lower now than in past years, and the Street doesn't consistently reward “invest to grow” stories, particularly when they come from companies that are large and have already had their heyday as a growth stock. Even so, I think it would be a mistake to count eBay out, particularly with their payments business.

If eBay can grow its free cash flow at a long-term rate in the low-to-mid teens, a fair value of around $65 seems fair. Wall Street won't like any more talk of investing capital into future payments growth, nor any reticence to return capital to shareholders, but I think eBay is doing well in positioning itself for the long haul. At about 20% below fair value, these shares could still be a good buy, though investors shouldn't expect a smooth and easy ride.

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